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What’s going on with the Chinese dragon?

Kira Iukhtenko for Forex Report

According to IMF estimates, China became the world’s largest economy in the year 2014, judging by purchasing power parity, leaving the US in second place. The picture is not quite so simple though, starting out with the fact that Chinese economic growth slowed to 7.4 percent in 2014, the lowest in 24 years. The IMF expects India to outpace China’s growth in the year 2015 (6.5 percent versus 6.3 percent respectively), and, to top it all off, economists have expressed concern about the reliability of either party’s data.

So what’s happening in China? The development model that has pushed the economy onward and upwards over the past few decades appears to have lost its way. That’s why Beijing has publicly proclaimed a so-called “soft landing”, and shifted the focus from exuberant growth to a more moderate one based on domestic consumption. And where once China relied on foreign investment, economic growth is now to be supported by more market-oriented structural reforms. Established economic features such as export-oriented industries, high investment-volume and a flourishing property market have each become a drag on the country.

Economists from all around the world are focusing on whether the Chinese government can keep the situation under control or not, and if there is a possibility that the soft landing might mutate into a hard one. For instance, the recent trade data raises serious concerns about the economy’s performance. January data showed that Chinese exports fell by 3.3 percent year-on-year in January, while imports plummeted by almost 20 percent, representing biggest contraction since the year 2009. What’s more, China’s two largest export consumers – Europe and China – are fighting deep economic problems with consumption subdued amid a low-inflation environment.

Deflationary threat

The most recent data shows that the Chinese economy is facing the risk of deflation. Housing market slippage and overall excess plant capacity coupled with falling energy prices and geopolitical conflict lowers the inflationary pressures. China’s consumer prices rose by an annualised rate of 0.8 percent in January, again, the lowest since 2009. And falling prices have hurt the profitability of Chinese producers, compounding existing economic weakness. The producer price index fell by 4.3 percent year-on-year, extending factory deflation to almost three years, and China was home to the biggest capital outflow since at least 1998 in the last quarter.

Central banks from all over the world are stepping into a period of loose monetary policy and aiming to support economic activity in that way. The People’s Bank of China doesn’t stand on the sidelines, but tries to act with caution: the bankers have to balance stable economic growth with planned economic reforms. The regulator lowered the key interest rate from six percent to 5.6 percent in November 2014 for the first time since 2012. And in February the PBOC cut the Reserve Requirement Ratio for banks from 20 percent to 19.5 percent, injecting $100bn into the financial system.

China GDP growth, % (2004-2014). Source: National Bureau of Statistics

However, the measures are not enough to turn the tide. China’s debt burden surged from 100 percent to 250 percent of GDP over the last eight years and it’s becoming more and more expensive for the country to serve the debt. Economists are worried rather by the prate at which the debt is growing than by its amount, raising concerns that the high debt burden and slowing growth could make capital usage highly inefficient and counterproductive. The theory is confirmed by China’s famous “empty cities” (built, but not settled) and by massive industrial overcapacity. Many countries suffer from a higher debt-to-GDP ratio (260 percent of GDP in the US, 277 percent in the UK and 415 percent in Japan). However, debt growth in these countries is much lower than in China. What’s more, these countries fall into the developed and not developing category.

Worrisome growth forecasts

Goldman Sachs projects Chinese economic growth will reach a moderate seven percent in the year 2015 and economists are citing tighter credit conditions and a slowdown in the housing market as the reasons for. However, they see no direct risk that the economy might slip into deflation, as China’s monetary authorities are standing ready to intervene if economic or price growth slows dramatically. All in all, Goldman remains rather optimistic, forecasting that lower commodity prices will support Chinese manufacturing and consumption.

Meanwhile, the former People’s Bank of China advisor Li Daokui reassures GDP growth is now approaching its lowest rate at around seven percent. In his view, China’s economy will likely accelerate in the next two years and the government clearly sees some limits to the current slowdown. Concerns about the economic stability and the labour market will certainly increase if growth falls below seven percent, however, and a sharp slowdown could raise social instability and unrest. There are also adverse economic risks contained in the rapid reduction of housing market investment. 

Existing problems are putting more and more pressure on the Bank of China to ease monetary policy further. The PBOC still has plenty of options to stimulate the economy in that borrowing costs remain elevated, while inflation keeps on falling. A reserve requirement ratio of 19.5 percent leaves enough room for reduction and the benchmark interest rate (5.6 percent since November 2012) is also far from the zero levels that pushed the Federal Reserve, Bank of Japan and the ECB to launch quantitative easing. History shows that a reserve ratio cut is rarely alone in China, and the last two cycles brought three RRR cuts and were followed by lower rates.

Economists at major banks (Deutsche Bank, Bank of America, Nomura Holdings and others) are forecasting more cuts in the PBOC reserve ratio and key interest rate in the coming quarters. For example, Deutsche Bank expects the reserve requirements to be lowered by another 50 bps in the second quarter along with rate cuts in spring. Without additional stimulus economic growth could dip below seven percent in 2015, Deutsche Bank warns.

China CPI, % (2004-2014). Source: National Bureau of Statistics

How to profit from China’s slowdown?

Why does the global economy care about Chinese slowdown? China is the world’s largest consumer of industrial raw materials, so the slowdown is a reversal point for commodity markets. The Celestial Empire sets up demand for the majority of the commodities especially iron ore, copper and coal.

Commodity-related currencies will clearly be hit by the ongoing slowdown. For instance, iron ore price crashed by 47 percent in 2014 and is extending declines this year. As a result, the Australian dollar plummeted to 0.77 US dollars in early 2015 and the Reserve Bank of Australia unexpectedly returned to cutting interest rates on the back of the commodity crisis. Economists expect one more RBA rate cut to follow in spring, so get ready to profit from a new wave of AUD/USD sell-off.

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