At the beginning of the year, most financial market participants were watching China. Specifically, analysts were watching for further signs that China’s policymakers had lost control of the country’s currency and economy, a slipup which could lead to massive capital outflows, a hard landing for the Chinese economy and a devaluation of the yuan, all of which would send shock waves reverberating through the global economy.
Recently, concerns about the state of China’s economy have evaporated, thanks in part to policymakers’ actions that seem to be keeping Asia’s largest economy on the straight and narrow. Still, there’s that massive debt pile to worry about which appears to be growing larger by the day and China’s bears believe that this will be the country’s downfall.
However, whether or not a global financial shock emerges as a result of China’s inability to keep its debt levels under control is splitting opinions on Wall Street. Indeed, over the weekend Morgan Stanley published a short research note by Chetan Ahya, Global Co-Head of Economics and Chief Asia Economist, in which the Economist claims that the risk of financial shock in China is low thanks to three unique characteristics of China’s current macro set-up:
“i) Debt is being largely funded domestically, i.e., China is misallocating its own excess saving; ii) It remains a net creditor to the world (with a net international investment position of 14.7% of GDP) and it runs a current account surplus; and iii) It is facing significant disinflationary pressures, which will allow the central bank to inject liquidity to manage any potential risk-aversion in the domestic financial system.”
China: No crisis but a thorn in global growth
The size and wealth of the Chinese state indicate that policymakers will be able to bring about change to the country’s economy without a large sudden, violent readjustment. An ideal solution to the country’s current problems would be to cut excess capacity, reorganise non-performing loans, recapitalise banks, cut real interest rates and stimulate consumption. However, considering the risks to social stability a quick economic readjustment involving all of the above factors is unlikely according to Chetan Ahya. While this implies that there will be no global financial crisis as a result of China’s debt dependency, unfortunately, it indicates that China will weigh on the trend in global growth and returns as it struggles to balance. As Chetan Ahya explains:
“This gradual adjustment approach would leave us with the outcome of an extended period of excess capacity, disinflationary pressures and declining nominal growth and returns in the economy…Although China has slowed its investment since 2012, we expect it to invest 41% of its GDP (US$4.7 trillion) in 2016…China currently needs new investment of 6.4pp of GDP to achieve 1pp of GDP growth, compared with the average of 3.6pp between 2000-07.”
“Against this backdrop, we think that China will weigh on the trend in global growth and returns. In a globalised, integrated economy, the impact will extend well beyond China’s weight in the aggregates as it will also influence returns in other parts of the world…China accounted for 26% of global annual capex in 2015, compared with 9% in 2006 and 5% in 2000. Hence, as China continues to invest with low return expectations, we believe that this will continue to weigh on the global returns on capital employed.”