Posted on September 17, 2016

The two most recent market turbulences were caused by concerns about the Chinese economy. While the January 2016 market volatility was triggered by fears about a potential Chinese currency crisis, the turmoil of August 2015 was caused by worries about a possible disorderly slowdown in China. However, market attention seems to have been diverted away from China as the focus has shifted to other global issues such as Brexit, the US Federal Reserve and the Japanese economy. This raises the question whether things have genuinely improved in China or whether markets are being complacent. We believe that on both the currency and the growth fronts, risks in China have subsided.

Let us start with the currency situation. The market turbulence in early 2016 was triggered by large capital outflows from China, representing Chinese borrowers repaying some of their external debt. The move was motivated by the cuts in Chinese interest rates, expectations about higher US rates and potential devaluation of the Chinese currency. These factors would have resulted in higher debt service burden for Chinese residents borrowing in foreign currency. The resulting large capital flight put downward pressure on the yuan, which forced the authorities to use their reserves to defend the currency. The large drawdown of reserves, which declined by nearly 20% between mid-2014 and January 2016, spooked investors who worried about an out-of-control weakening of the yuan.

However, the situation seems to have stabilised recently. International reserves have been maintained at around USD3.2tn since February 2016. Going forward, the International Monetary Fund (IMF) expects pressure on the currency to ease as outflows related to external debt repayment decelerate. External debt has been reduced from nearly 17% of GDP in 2014 to around 12% currently, according to the IMF, which also believes that the current stock of debt is less sensitive to interest rate movements or expectations about future currency direction as it is mainly related to trade financing.

Regarding growth, have things improved on that front? ‘Hard’ data (such as real GDP growth, retail sales and industrial production) suggest that the economy has slowed down in an orderly manner, reducing fears about a potential hard landing. But survey data, which tend to be more forward looking, suggest that activity has turned a corner since it bottomed out in September 2015 (see chart). Furthermore, survey data point to a broad-based pickup in activity, covering both the manufacturing and the service sectors. What caused this uptick in Chinese activity? Mainly policy stimulus from the authorities on both the monetary and fiscal sides. On the monetary side, interest rates were cut five times in 2015. As a result, three-month deposit rates fell from 2.35% in early 2015 to 1.10% by October 2015. On the fiscal side, the policy stance has become expansionary in 2015 having been contractionary the year before.

However, while these policy initiatives have managed to boost growth in the short term, they risk causing problems in the medium term. Policy stimulus has resulted in higher infrastructure spending, faster credit growth and stronger activity in real estate. But these are the same variables that China is trying to put a lid on as part of its transformation plan. Indeed the idea of rebalancing the Chinese economy away from investment and towards consumption was motivated by fears that large capital spending and rampant credit growth have resulted in sizable spare capacity, particularly in real estate and infrastructure. In that respect, Chinese policymakers are walking on a tightrope between stimulating the economy to avoid a hard landing and transforming the economy to avoid creating more empty roads and ghost cities.