Turmoil behind The Great Wall
PEOPLE once called China the “sleeping giant” but as it shifted from a centrally-planned to a market-based economy in the late 1970s and thereafter opened up to global trade at the turn of the millenium, it has awakened to become the factory of the world and a major global growth engine.
It grew its gross domestic product (GDP) by an average of more than 10 percent in the last decade, lifting 500 million people out of poverty. As it rose to become an economic superpower—the second largest economy in the world—it also built enormous foreign exchange reserves and boosted its military capability.
In recent years, however, China entered a rough patch. The World Bank said China’s rapid economic ascendance had brought on many challenges, including high inequality, rapid urbanization, challenges to environmental sustainability and external imbalances. These are alongside demographic pressures related to an aging population—a result of the one-child policy— and the internal migration of labor.
Economic rebalancing
The global recession triggered by the US-epicentered global financial crunch of 2008-2009 further exposed China’s vulnerability to external demand. The government thus strategized to rebalance the economy—from an investment-and export-oriented model to a more consumption-driven economy—to better focus on sustainability and improving quality of life for its 1.3 billion population instead of being obsessed with the pace of growth. In the meantime, wages have risen in coastal areas due to labor shortage, prompting big foreign manufacturers looking to expand operations to either move operations inland or consider options elsewhere in Asia, in some ways benefiting the smaller open economies of Southeast Asia.
Economic hard landing has thus been a recurring fear among investors. The pace of growth is now at its slowest in over two decades even as local governments continued to fuel a construction boom while circumventing borrowing limits. Consensus forecasts point to China’s gross domestic product (GDP) growth slowing from 7.3 percent last year to 6.8 percent this year and further to 6.6 percent next year notwithstanding a number of stimulus measures.
“China is likely experiencing a prolonged period (three years or more) of slow growth,” Citigroup economist Minggao Shen said in a research note dated Sept. 28. More pessimistic than market consensus, Shen has kept a growth forecast of 6.3 percent for 2016 while acknowledging that actual growth could further be curbed to between 4 and 5 percent. “Broad recession remains a risk and the timing and quality of policy reaction are critical to reduce this risk,” Shen said.
No soft landing
Economists Ludovic Gauvin and Cyril Rebillard, in a July 2015 research for Banque de France, are among those who don’t subscribe to consensus forecasts of a “soft” landing. They said China’s investment-biased growth model that heavily relied on low exchange rate, low wages and low interest rates seemed to have reached its limits, as reflected by the continuous growth deceleration since the beginning of 2011.
“Vulnerabilities are mounting, due to overinvestment, excess capacities, a strong rise in the credit-to-GDP ratio— especially when taking into account shadow banking (non-bank lenders catering to high-risk borrowers)—and a probable real estate bubble. Although the Chinese authorities are committed to rebalancing the economy toward greater private consumption, they have not been successful so far, with an investment-to-GDP ratio still at record high levels,” Gauvin and Rebillard said.
Gauvin and Rebillard have projected a more pronounced slowdown which would eventually settle at a meager 3-percent growth per year. They see the bursting of a real-estate bubble as a potential trigger for a hard landing, as what had happened to Japan at the beginning of the 1990s.
They noted that housing had been the main alternative investment vehicle for Chinese households in search of higher returns than the capped-rate deposits while land sales had been an important source of funds for local governments whose expenditure requirements way exceeded limited fiscal revenue and central government infusion. Apart from rising price-to-income and price-to-rent ratios, the economists said extremely high—and still rapidly rising—cement production levels were making the Chinese context “look worse than any of the past known cases of real estate bubbles.”
‘Black Monday’
In the meantime, China’s surprise devaluation of the yuan to a three-year low last August following a string of bleak economic data only escalated growth jitters and, two weeks after, precipitated a global meltdown of stocks on Aug. 24, or the so-called “Black Monday.”
The Philippine Stock Exchange index then lost 487.97 points in a single day, the biggest decline seen in a single day in terms of number of points. The 6.7-percent single-day decline wiped out P764 billion in local market capitalization.
The Asian Development Bank (ADB) does not see a hard landing for China but considering its importance in the world economy, the Manila-based multilateral lender noted that “even a soft landing may undercut global recovery.”
Apart from being a major exporter, China is also a big importer especially of raw materials especially of energy and base metals. Its slowdown is therefore bad for commodity prices. ADB estimated that its share of world iron ore imports averaged 67 percent from 2012 to 2014 while China likewise gobbled up more than 30 percent of copper imports alongside the big bulk of coal and crude oil over the same period.
Even when the US economy is improving on the other side of the world, the weaknesses in China have thus shaken up global markets. China’s woes have even affected the US monetary policy, being cited as one reason why the US Federal Reserve did not raise interest rates in September.
“China has been a big driver of growth, so it’s the nature of the pause and how long it takes that will have any impact in terms of world growth. If you look at it structurally and for a long period of time, my own view is that China will continue to grow and will have a positive impact on the world economy.
From our perspective, the volatility of the financial markets has been overblown,” said William Connelly, global head of ING commercial banking.
The World Bank said that significant policy adjustments were needed to make China’s growth sustainable, noting that transitioning from middle-income to high-income status was historically more difficult than moving up from low to middle income.
To date, China’s per capita GDP of $6,747 is enviable when compared to the Philippines’ $2,800 but it’s still meager compared to the United States’ $53,101, Germany’s $44,999, France’s $43,000 and United Kingdom’s $39,567 per capital GDP. This means that even if China becomes the world’s largest economy any time soon, its living standards will still be way below “First World” standards.
Devaluation Jitters
On Aug. 11, global markets were caught offguard after China’s central bank devalued the yuan by almost 2 percent, bringing the local currency to its steepest fall since the previous devaluation in 1994. There have been talks that further devaluation may be sanctioned for it to regain competitiveness, which in turn may trigger the “beggar-thy-neighbor” currency wars, referring to an international trading policy that utilizes currency devaluation and protective barriers to alleviate economic difficulties at the expense of other countries. The fear was that a number of Asian countries would likely tolerate if not engineer a weakening of their own local currencies to cope with shockwaves from China.
When finance ministers from the 21-member Asia-Pacific Economic Cooperation (Apec) group met in Cebu last September to draw up an action plan, part of the ministerial declaration was to address economic weaknesses without engaging in the much-feared currency wars.
“Now that the Federal Reserve has stayed its hand in interest rates following the currency shock last August, the multibillion dollar question is whether China will devalue the yuan again,” said Jose Mari Lacson, head of research at local stock brokerage Campos Lanuza & Co.
“Because of this, economic data releases from the US and China over the next couple of months will likely drive uncertainty in the markets in the near term.” Further tinkering with the yuan could lead to a significant realignment of both trade and capital flows in the region, Lacson said.
BPI Securities chief executive officer Michaelangelo Oyson said exchange rate volatility would not be good for the stock market. “Currency is important because it will have an impact on foreign funds’ allocation. If they expect the currency to weaken, they will pull out funds ahead of further depreciation so there’s a second-order effect,” Oyson said.
On the other hand, Oyson said the impact on the Philippine economy of a weaker currency might be “more muted than it appears to be.” In 2008, he noted that despite the sharp peso depreciation, the domestic economy continued to grow after a blip that lasted only for one quarter.
Edward Teather, an economist at UBS, said a 10-percent depreciation of the Chinese yuan against the US dollar would have a significant impact on Asia’s currency markets.
“Initially, an exchange rate appreciation relative to trading partner currencies should result in contracting exporter margins – as the local currency price of exports falls – and increased purchasing power domestically – since imports cost less. Conversely currency depreciation will boost exporter margins and reduce domestic purchasing power,” Teather said.
“In the longer run, prices, export or import volumes and ultimately wages may respond to the changes in exchange rates. How this plays out is much harder to predict than the initial impact on export margins and domestic spending power.”
A 10-percent yuan depreciation against the greenback, Teather estimated, might lead the Philippine peso to replicate 40-80 percent of the corresponding yuan decline against the US dollar.
Teather said central banks in the region might also consider higher policy rates alongside measures to control the flow of capital if they judge the decline in the currency to be more destabilizing than slower growth.
“However, we suspect the bias across Asia will be to avoid policy rate hikes and perhaps ease policy if at all possible on account of the clearly visible economic fragility implied by the mature domestic credit cycles and difficult export environment,” he said.
Ripples in PH
Apart from foreign exchange pressures and the exit of foreign portfolio funds or “hot money” that we’re already seeing, another potential impact of turbulent asset markets in China could be foreign direct investment flows.
“If the fall of China’s stock market affects the balance sheet, liquidity and overall creditworthiness of Chinese companies, particularly the multinationals, then we could see local partnerships with them at risk. Similar to what is going on with Phoenix Semiconductor, whose parent company is undergoing bankruptcy proceedings, a weakened Chinese parent could have a negative impact on a subsidiary that has invested or partnered here in the Philippines. The subsidiary may not be able to fulfill its capital commitments or even be sold by the parent to shore up liquidity,” Campos Lanuza’s Lacson said.
“This really depends on the balance strength of the Chinese companies and their subsidiaries that are invested here.”
Lacson is hoping that China’s economic woes won’t go the way of the US of the previous century, where the roaring 1920s eventually led to the Great Depression of the 1930s with the great crash of the 1928-29 being symptoms of the economic overcapacity.
“But if it does lead to a major economic depression in China, there are several areas where we should be more worried about. Firstly, commodity prices such as copper and nickel, our two major exports to China, which is the biggest consumer of these metals,” Lacson said.
Geopolitical risks may also escalate if and when an economic depression results in harsh job cuts in China.
“We should expect their government to spend their way out of this (a Keynesian solution) and we suspect that the reclamation in the West Philippine Sea may be part of this strategy of economic expansion to sustain domestic Chinese economic growth,” Lacson said. “Runaway unemployment in China would also have implications for cross-border movement in the region.”
What is clear is that with China running out of steam, the rest of Asia—and the rest of the world for that matter— will be hit by stock waves in one way or another. It’s in everyone’s interest for the turmoil behind that Great Wall to be addressed.
