China: The Domino Effect

China: The Domino Effect

There is a significant level of debate and several reports, as well as articles that have been issued recently, regarding the current situation of Chinese economy and the forecasts on its future course. Concerns raised are not inexcusable, if we take into account that China is the second largest economy in the world and is considered as the greatest “engine” of global growth. Over the last 30 years it has sustained fast economic advancements, enabling its population to improve its living standards and making investors globally to be more than willing to invest in such a sustainable evolvement. However, China is recently facing the risk of a possible economic recession, which may contribute to a slump in world stock markets, as well as to the conformation of global economy.

Opinions regarding the economic course of China widely differ. On the one hand, there are various analysts who declare that investors worry unreasonably and markets overreact as China’s economy grew by almost 6,9% in 2015, compared with 7,3% the year before, which is the lowest growth rate since 2009- but is still a good margin! On the other hand, many other researchers are almost sure that the world’s second-biggest economy is far weaker than economic statistics show. To make the above more comprehensive, China’s reports for GDP are issued in Yuan terms. Yet they have to be released basis on U.S. dollar, which is an international currency, in order to compute the impacts globally. In this point of view, results may not be pleasant. As depicted in the picture below, although China’s GDP average growth was around 15% during the period of 2010 till 2014, it had slowed extremely down in 2015.

In addition, although the general government debt at 55% of GDP in 2014 (from 42% in 2007) remains reasonable, the good image can easily be reversed, if we take into account local governments’ amount of dept, together with the private debt (banks, firms and households). In this point of view, total debt stands to 282% of GDP and although it still remains lower than the US equivalent to 331.7%, it still creates destabilizing conditions. Trade volumes have also decreased as export sector declined by nearly 2% and imports by almost 11% in dollar terms, compared to the same month in 2015. Manufacturing index has also decreased below 50, which indicates an immense contraction of subject sector.

It is also an undeniable fact that economic sectors of construction and heavy industry, that drove China’s growth from 2000 to 2013, are currently declining. Services and consumer spending, sectors that offer solid employment levels and wave gains, remain strong and represent the biggest part of China’s current economy, but unfortunately are not strong enough yet; at least not strong enough to support the entire economy.

Another important fact that makes investors and researches worried, is that the markets of China are regarded as significantly overvalued according to many bank estimates, such as Goldman Sachs. Their value rose by about 150% in one year (May 2014 – June 2015), despite the downward trends of Chinese economy at that time. In June 2015, their value reached 10 trillion dollars, while during the period of 2013-14, when the country had greater growth, it was around 4 trillion! China’s stock markets have lost 3.25 trillion dollars in a month in 2015 and a total of 4.5 trillion dollars from June 2015, according to Bespoke Investment Group and Bloomberg respectively. The situation deteriorated even more at the beginning of 2016, when the stock markets lost about a trillion dollars after the drop of Share prices by almost 7%. As a result, markets have already been interrupted twice this year and Chinese Central Bank has accelerated the devaluation of Yuan to the lowest level since 2011, in order to boost Chinese exports and strengthen the economic transactions towards the significant drop in industrial activity.

Despite the above devaluing, the situation is not expected to improve. Many analysts predict further devaluation at least by 12% against dollar by 2017 and believe that China’s stock market is unlikely to stabilize, unless their value falls to 2012-2014 levels, which in turn means an extra drop of about 33% of the current value. Such a high volatility in the exchange rate markets, which is depicted in the following chart, raises questions regarding the course of Chinese economy. The above situation combined with government’s intervening policies, which oppose to the “free market” and are considered as essentially uncontrollable reactions, cause panic, increase investors’ lack of confidence to the Markets and make them ‘’nervous’’ as well as suspicious regarding the sustainability of growth.

Apart from the above immense volatility, investors’ uncertainty is also enhanced by the fact that, in contrast with most international markets, a large number of Chinese individuals (about 7% of the population) have invested significant amounts in the stock markets, a number which is constantly increasing. Private placements in shares represent 20% of the assets of a Chinese average household, in relation to the savings that account for 45% of the labors of a lifetime, while the total market capitalization of Chinese listed corresponds to 45% of GDP, compared with 115% in the US and 97% in N. Korea respectively. According to Deutsche Bank, 66% of China’s small individual investors have not graduated from high school and 6% are illiterate and totally ignorant with respect to the markets. As a result, their investment behavior is prone to forecasts and facilitates many speculators to take benefits at the expense of Markets stability.

The above facts are considered by many analysts and researchers as some indications of a serious recession threatening country’s economy. The ‘’fate’’ of Chinese giant is definitely not the only factor that would affect world economy in the future, but is considered without a doubt one of great importance for various reasons.

Firstly, China has a dynamic perspective on the internal consumption and demand. It is also the biggest global importer of raw materials, energy and consumer products worldwide, and the number one exporter for numerous products since 2013. It has significant trading relations with USA, EU, Hong Kong, Japan and South Korea and is simultaneously encouraging trade with African nations as with many Latin American countries, from where it imports raw commodities, such as oil and other fuels, metal ores, aluminum, plastic and organic chemicals.

Unfortunately, trade volumes have decreased and demand for raw materials and other goods purchased from China’s main trading partners have been seriously affected. This in turn has hurt and is expected to further hurt not only emerging economies- which depend on row materials exports, such as Brazil- but also manufacturers and construction industries in developed countries, such as USA and Japan. Things will get even worse in case of a further devaluation of Yuan, as the dollar value of the Chinese goods will be reduced further. Significantly vulnerable are countries such as South Korea, Japan, Indonesia, N. Africa, Saudi Arabia, Russia, Brazil and Venezuela, which are depended mainly on Chinese demand for oil, metals etc., as the largest percentage of these countries’ GDP is based on Exports and Imports. The following chart indicates the impact of Chinese economy slowdown in several countries’ GDP globally.

Especially in Europe, a sharp drop in exports is not likely. Europe exports rate of raw materials to China around 8% which sums up to roughly 1% of Europe’s GDP. As a result, the direct effects of Chinese economy to Europe are expected to be of minor importance. Nevertheless, indirect consequences could be unpredictable. Europe’s Banking System is International, so the risk of financial contagion originating in China cannot be dismissed. Many European Banks, such as in Germany and in France, have lent money to Chinese banks in recent years and have now a great exposure to Chinese Banks’ non-performing loans. In addition, other Banks like Spanish, have not lent money to China extensively but hold assets of great value in Latin America, which now is suffering from the declining Chinese demand.

A possible capital flight is another arising risk in case Chinese stock market keeps on dropping. A great amount of money is already subsiding; as investors have already pulled billions of dollars out of China. The Central bank may devaluate further its currency in order to offset outflows. But this in turn, may impel other countries to also devaluate their currencies or enforce various protective measures in order to immunize their commercial interests. Such a development, unfortunately, reminds us similar events that eventually led to the outbreak of World War II. Charter below shows estimated Capital Flows since 2006.

Finally, we should not forget to mention the potential consequences for Chinese nation in itself, which would most definitely not be pleasant to say the least. The political leadership of the country is currently betaking to the expansion of domestic consumption and the gradual liberalization and internationalization of some Chinese production sectors. Such reforms in combination with a further slowdown of Chinese economy may lead to socio-political unrest. Strikes, labor struggles, workers’ protests etc could arise. Already increased unemployment will rise further throughout the country, and especially in urban regions. Poverty incidents will multiply, health and education system will deteriorate and living standards will be negatively affected. The Chinese population may return to the rural and poor society it was before the Chinese economy growth -approximately three decades ago.

To conclude, it is the first time in global modern history that a vast country is in such a critical economic juncture. The importance of the Chinese economy is obvious and gives a clue on how any developments in China, negative or positive, can influence the world’s largest economy and the world economy overall. In the effort of an economic boost, the conversion of the traditional Chinese Saver to an Investor has been the main objective of the Chinese government, as part of a wider strategy to shift economic activity from exports to consumption and the enhancement of internal demand. Chinese Authorities realized that in order for the economy to develop effectively they had to overcome several difficulties such as environmental issues, huge amounts of debt of regional governments and corruption incidents, the emergence of Chinese middle class consumers, oversupply in the manufacturing sector etc.

The question which arises is whether China is able to successfully overcome the above obstacles and transit from an economic model focused on industry and investments to a new one based mainly on services and consumer spending, and the extent of damage it could cause worldwide. Such structural reforms require a lot of time and hard efforts but unfortunately, up to now, have not been smooth enough. For instance, despite the extensive efforts to encourage private sector to participate in the numerous inefficient state companies (in order to limit State interventionism, eliminate financial corruption incidents and improve their management), yet to date only a handful of mixed-ownership deals have been completed, and many of them involve the transfer of shares to state-owned investment companies, with no private-sector participation. Contrariwise, the number of state enterprises has increased by approximately 50.000 since 2008.

There is definitely the optimistic viewpoint as well, as many analysts claim that the situation in China can be reversed and kept on a growth path, if reforms are carried out properly. Some signs of economic stabilization have recently emerged, mainly due to the increase in property prices and the opposition of capital outflows. Indicative is the fact that during March, for the first time – after five months – the reserves of China in foreign currency rose. Therefore, harder efforts are required so that China proves its willingness to successfully follow the required changes in order to regain market confidence. Nonetheless, strong confidence to the markets always enhances economy’s stability, strengthens investment eagerness and growth inevitably comes.

Written by Ms M. Fioraki, Trader @ Gram Marine Pte Ltd

2560 1422 Gram Marine
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