How will China walk the tightrope between stimulating growth and the need to rein in debt?
Nicholas Spiro says the recent strains on China’s economy have not entirely spooked investors, but the country has a tough economic balancing act to perform
The dramatic sell-off in China’s equity and foreign exchange markets over the past several months has revived memories of the turmoil in the second half of 2015 and early 2016, when the unexpected devaluation of the yuan and a collapse in stocks wreaked havoc on global markets.
The severity of the price declines this year, and the gravity of the external and domestic threats weighing on sentiment towards China, have once again turned the world’s second-largest economy into a focal point of market anxiety.
It is not surprising that investors are having flashbacks of the 2015 crisis. In the space of just 11 weeks, the renminbi has lost more than 7 per cent against the US dollar, compared with 5 per cent during the six-month-long sell-off that followed the surprise devaluation of the currency in August 2015. The Shanghai Composite Index, meanwhile, entered bear market territory last month while Chinese high-yield bonds have suffered the sharpest losses among the leading emerging markets this year.
The renewed nervousness about China’s economy, which stems partly from fears about the impact of a trade war with America, also contributed to a sharp sell-off in the commodity sector, affecting particularly the prices of industrial metals. The Bloomberg Commodity Index, a leading gauge of raw materials prices, has dropped by more than 7 per cent since the end of May.
Yet for a variety of reasons, some of them domestic but most of them external, international investors are downplaying the recent strains on China’s economy and markets, easing some of the pressure on policymakers.
The clearest indication of this lies in the strong performance of global equity markets, particularly US stocks, which suffered steep declines during the previous sell-off. The MSCI World Index, a leading gauge of shares in advanced economies, is up by more than 3.5 per cent over the past three months while the benchmark S&P 500 index has shot up by more than 7 per cent and has recouped nearly all its losses since suffering a correction in early February.
Equity markets remain buoyant partly because global growth is on a much firmer footing than in 2015. Monthly purchasing managers’ index (PMI) surveys for the manufacturing and services sectors, which in early 2016 were close to levels that pointed to a contraction in output, reveal that the world economy, although slowing, is expanding at its briskest pace in 3½ years. Data published last Friday showed the US economy grew at an annual rate of 4.1 per cent in the second quarter, its fastest clip since 2014.
Just as importantly, investors remain bullish on the technology sector, despite concerns about valuations and future growth. According to the results of this month’s fund manager survey by Bank of America Merrill Lynch, a long, or overweight, position in the world’s largest tech stocks – which include China’s Baidu, Alibaba and Tencent, known as the BAT – was the most popular trade for the sixth straight month.
During the previous China-led sell-off, the most crowded trade was an overweight position in the dollar, which put further strain on Chinese and emerging market assets.
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Investors also believe China itself is in a stronger position to cope with the current turmoil. Not only is the rampant capital flight that fuelled the depreciation of the yuan in 2015-16 visibly absent this time around, the slowdown in China’s economy that is partly responsible for the sell-off has forced a shift in policy away from deleveraging towards growth-supportive measures.
Beijing’s recent decision to provide more stimulus has helped stem the decline in Chinese and emerging market stocks and, according to a report published by JPMorgan last Friday, contributed to the strongest month for global asset prices since January.
Make no mistake, this time around, China has the markets on its side, so much so that the latest burst of stimulus – which comes at a time when the world’s other main central banks are considering tightening policy – could become the key driver of markets in the coming months.
Still, a Chinese stimulus-induced rally carries significant risks, particularly as it is being propelled partly by the depreciation of the renminbi which, if sustained, could lead to the resumption of large capital outflows.
More importantly, the recent steps to boost liquidity and stabilise growth raise the stakes in China’s perilous balancing act on debt. Beijing’s stimulus measures, although much more modest and circumscribed than in previous years, show how difficult it is to push ahead with deleveraging in the face of a trade war while maintaining decent growth.
Chinese policymakers are still hoping they can achieve both of these objectives simultaneously. Investors are playing along. How long markets will remain on China’s side, however, is another matter.
Nicholas Spiro is a partner at Lauressa Advisory