Fears over a 'tail risk' hard landing in China are growing

Any slump in the mainland economy will inevitably cause casualties including Hong Kong because of the banking sector’s exposure

PUBLISHED : Thursday, 20 February, 2014, 1:10am
UPDATED : Thursday, 20 February, 2014, 8:23am

Yesterday, the South China Morning Post reported how Beijing's central propaganda department has instructed mainland media organisations not to give air time or column inches to foreign bank economists worried about the dangers posed by China's ballooning debt levels.

As a crisis prevention measure, that's like thinking you can eliminate the threat of a fire by disabling your alarm.

Yet while Beijing is keen to play down the risks, private sector analysts are getting increasingly concerned.

Most believe that China's economic growth rate is likely to stay above 7 per cent over the next couple of years at least. That's what China's leaders have decided is the slowest acceptable growth rate, and recent history shows they have the tools to support economic growth as well as the willingness to use them.

But although a painful period of deleveraging which pushes growth below, say, 5 per cent may not be the most probable outcome for the Chinese economy, it remains a possibility. And the effects should China experience such a hard landing would be so severe and so widespread that the scenario, unlikely though it may be, merits careful examination.

While Beijing is keen to play down the risks, analysts are … increasingly concerned

Asia's private sector analysts clearly think so. In a report published yesterday, Tim Condon, the chief economist for Asia at Dutch banking giant ING, argued that just as China's rapid growth in the 2000s lifted economies across the world, so a Chinese slowdown will inevitably cause casualties.

A 30 per cent deceleration in China's growth rate could lead to a halving in global export growth, he estimated. "Investors should be prepared for a crisis or two in emerging markets," he warned.

Also this week, economist Wang Tao and her colleagues at Swiss bank UBS pointed out that Hong Kong is particularly vulnerable to a Chinese slowdown. Mainland visitors account for 30 per cent of the city's retail sales, they noted, while exposure to China makes up almost 20 per cent of the local banking system's assets.

Markets that export to the mainland would also be hurt by a hard landing, especially if their exports are driven by domestic demand rather than the mainland's processing for re-export trade. Among the most exposed are Taiwan and Korea, both of whose exports to the mainland are worth more than 6 per cent of their GDP.

Way off the charts, however, stands Mongolia. Not only are almost 90 per cent of Mongolia's exports bought by China, but in recent years the country has seen a massive boom in credit funded by foreign capital inflows; inflows which would quickly vanish if Chinese growth were to slump.

Happily, it is possible to take out insurance against a hard landing. To make things easy, Jonathan Garner and the cross-asset research team at Morgan Stanley have compiled a list of the markets most likely to be affected, and worked out how investors can hedge against any coming slump.

For example, they estimate that a hard landing in China would depress the earnings per share of Hang Seng Index companies by 25 per cent, which in turn would drive a 32 per cent fall in the index level.

For protection, Morgan Stanley recommends that investors should buy one year put options on the index, which would pay out five times over if their forecast proves accurate.

Alternatively, investors could buy out-of-the-money put options on the yuan in Hong Kong's offshore market. A hard landing, believe Morgan Stanley's analysts, could see the Chinese currency fall by 16 per cent against the US dollar in the offshore market, in which case their hedge would pay out almost 17 times over.

The analysts at all three banks are careful to stress that a Chinese hard landing is still an unlikely "tail risk".

Nevertheless, it is a safe bet that none of them will getting an invitation to expound their views in the mainland's media.