January 29th, 2016 | By Nick Sargen
For those who like drama, it’s hard to conceive of a more auspicious beginning to a year than a plunge in China’s stock market and pressures on the yuan reverberating around the world, and culminating in oil prices falling below $30 per barrel. The most common interpretation is these developments could indicate a significant slowing in China’s economy. However, my own interpretation is that the market pressures are indicative of an ongoing loss of confidence in policymakers, which is evident from the sizable net capital outflows over the past year, which are estimated to have been in the vicinity of $1 trillion.
To understand what is happening today, one first needs to recognize that there has been a steady slowdown in China’s economy and other emerging market economies (EMEs) over the past five years. The high water mark for these economies was 2010, when they experienced strong growth as a result of rapid credit expansion and fiscal stimulus. More recently, however, growth in the emerging economies has been the weakest since the expansion began. As shown in Figure 1, growth rates for Emerging Asia slowed to 6.5% last year from a peak of 9.6% in 2010, while growth in Latin America and the former Soviet Union was mildly negative, mainly as a result of severe recessions in Brazil, Venezuela, and Russia. This weakening in emerging economies, in turn, has been accompanied by a slowdown in the volume of world trade and a steep decline in commodity prices.
Economic Growth (%)
Source: IMF, WEO.
Throughout this period, emerging market equities have underperformed their counterparts in the United States and other advanced economies considerably, and in the past year and a half EM currencies have come under considerable pressure against the dollar amid expectations that the Fed would tighten monetary policy. Thus, equity returns in U.S. dollars for the so-called BRICs (Brazil, Russia, India and China) have been negative in U.S. dollar terms over the past five years.
The main outlier in this period was China’s stock market, where the Shanghai composite index rose by two and one half times from mid-2014 to mid-2015, as China’s policymakers attempted to jaw-bone the market higher to offset concerns about the economic slowdown. This effort backfired when the market suddenly plummeted by 40% in the span of three months. To curtail these pressures the authorities imposed a ban on sales of equities by large institutions, but the selling pressures resurfaced at the beginning of this year, when the ban was set to expire. Thereafter, attempts by the authorities to extend the ban and to impose circuit breakers failed to calm the markets. In fact, concerns intensified when market participants interpreted China’s decision to alter its exchange rate policy to peg the yuan to a basket of currencies as evidence that the authorities were seeking to devalue the Chinese currency.
Meanwhile, the latest data on China’s economy have been mixed. A recent BCA Global Investment Strategy report (January 15, 2016) notes that the economy seems to be showing signs of life: “The property market has improved, auto sales have reaccelerated, money growth has picked up, and the number of new capital projects initiated has begun to recover.” The main area of weakness continues to be the manufacturing sector, which is feeling the impact of weakness in world trade. The services sector, which has supplanted manufacturing as the largest sector, has continued to expand at a solid pace, although the most rapidly growing component has been financial services, which received a boost from a surge in trading activity during the boom in 2014 to mid-2015.
At the same time, market participants have attributed the recent plunge in oil prices to softness in demand from China. However, this is not confirmed by the data. Rather, the main source of pressures have come from the supply side, where shale oil production in the United States has not fallen as much as was expected while Saudi Arabia has refrained from curtailing production and Iran is slated to step up its production now that sanctions have been lifted.
In short, while China’s economy has slowed steadily over the past five years, there is no clear-cut evidence that the pace of slowing has accelerated recently. There is no question China faces huge challenges ahead as it attempts to transition from reliance on export and investment-led growth to a strategy based on consumer-led growth. At the same time, the authorities claim to seek greater market-determination of interest rates and the currency, although they repeatedly have backed away from market reforms when economic growth falls shy of the official targets.
That said, it is relevant to consider where the risks of a hard landing are the greatest. In a previous blog (August 6, 2015), I noted that prior to the plunge in China’s stock market, the primary concern that investors had about China was whether it was at risk from a property bubble:
“Researchers at the BIS have identified this sector to have a potentially greater impact on economies than equity markets, mainly because real estate is typically purchased with leverage and financial institutions have significantly larger exposure to this sector than to equities. Currently, China and several other emerging economies are atop the BIS watch list for asset bubbles, mainly because of the rapid expansion of credit that occurred in the wake of the 2008 global financial crisis.”
I take these warnings seriously, as the BIS has done the best job of any institution studying financial crises and modeling them. At the same time, I believe the policy response to an asset bubble is critical in influencing the outcome, and thus far China’s policymakers have demonstrated greater flexibility in handling potential asset bubbles than their counterparts in Japan and the United States did. Moreover, should conditions deteriorate in the property sector, the authorities have flexibility to ease monetary policy and/or to pursue fiscal stimulus, including direct injections of capital into financial institutions. Still, I recognize this does not mean that China would escape unscathed, as a bubble in the real estate sector or stock market is indicative of a misallocation of resources. Accordingly, the primary risk I envision is that continued poor resource allocation could cause China’s economy to slow well below the official 6.5% target growth rate and possibly to experience the equivalent of a growth recession.
In short, I see formidable risks for the Chinese economy in the years ahead as it alters its growth strategy and attempts to liberalize its financial markets. However, based on the evidence thus far, I believe the latest growth scare is more indicative of a loss of confidence in China’s policymakers than a precursor of an imminent weakening of the economy.
While investors currently are fixated on China, I believe the risks of a full-blown meltdown are considerably greater in another BRIC – namely, Brazil. The reason: It is facing political instability and questions about financial sustainability at the same time. For the past two years, Brazil’s economy has been operating in what I call the “crisis zone,” in which its currency has plummeted by nearly 50% versus the dollar, while the central bank has had to raise short-term interest rates to 14.25% to counter inflation, which is expected to surpass 10% this year. This has occurred against a backdrop, in which the economy contracted in 2015 at a 3.8% rate, the most severe downturn since the 1930s.
This past week, Brazil’s central bank was expected to raise interest rates further; however, it backed off when the IMF issued new forecasts for the economy, which call for another steep drop in GDP this year. With monetary policy on hold, even as inflation continues to accelerate, the most likely outcome is Brazil’s currency will come under renewed pressure.
Brazil’s problem is compounded by the fact that its federal budget deficit has ballooned to 8% of GDP; yet, meaningful cutbacks in government spending are unlikely because the Brazilian legislature is highly fragmented. With public debt currently at 66% of GDP and borrowing costs well above nominal GDP growth, some forecasts call for the ratio to reach 90% in the next few years, with interest payments on public debt already equal to 12.5% of GDP. In July of last year, a BCA Special report “Brazil is Trapped” pointed out that the situation is even more precarious due to a sizable expansion in off-balance sheet or hidden public debt since 2010. Meanwhile, Brazil has been downgraded to junk status by Standard&Poors and it is currently on Moody’s watchlist for a possible downgrade.
One saving grace for the country is that its external debt is relatively low in relation to GDP, which lessens the risk of an external debt crisis. Nonetheless, one of the main takeaways of research by Reinhart and Rogoff is that domestic debt crises are more frequent than most people realize, and they can be extremely severe, especially when defaults leave the financial system vulnerable.