China has most certainly become the second largest economy in the world. The Chinese economy after experiencing spectacular growth over the last few decades, is now moving into a new phase of more intermediate development. Although the government officials will continue to insist that the domestic economy is still growing at a rate close to 7%, an increasing number of investors are beginning to have their doubts.
The legitimacy of the modern Chinese government, is now tied to providing the people and the country continued economic growth and prosperity. This will become progressively difficult as development inside the country matures, along with a period of more sluggish global expansion. As a result, the political leadership is likely to embark on a policy of increasingly desperate and disjointed financial moves to attempt to maintain faster growth.
The other fail safe action, is to exaggerate and obfuscate economic data. It is a traditional policy that had become far less important in more recent times, when the Chinese economy was rapidly expanding. Now that a new phase of slower and negative growth has arrived, this will be a survival tactic that will become far more prevalent.
Many analysts abroad had already expected as much. It was becoming more arduous to believe official pronouncements on government provided data, that seemed to consistently understate what had become obvious to most observers. That is the Chinese economy, was slowing down appreciably.
Trying to change economic data to shield the government in power from the unfortunate consequences of poor policy, is rampant worldwide. Witness the recent developments in Argentina, Brazil and Venezuela in just the last two years alone.
Times are somewhat different inside China today and authorities there, can no longer treat the populace to outright propaganda on a daily basis. The citizenry has become far too educated and sophisticated for that. To have any credibility, the regime must acknowledge what can clearly be recognized as fact. Rapid economic growth will no longer be possible on a consistent basis. The goal of the government at this point, is to manage the deceleration so it does not become a major political liability.
That is why data was released at the beginning of the year, that indicated economic activity was continuing to slow. It marked the 10th month in a row of this phenomena. Of course, such negative news had immediate consequences. By the end of the week, the main stock exchange of China known as the Shanghai Composite was down 10%. In just a week all the gains from 2015 were wiped out. The Chinese government responded with the largest infusion of cash since September. A sum equal to $19.5 billion USD (United States dollar) was made available to avert a panic.
A further action of regulators inside China, was to have in place circuit breakers that would shut down trading, if the market exceeded a loss of 7%. It only made matters worse, as it needed to be employed twice in the first few days of trading. By the end of the week, Chinese officials changed course yet again. There would no longer be any automatic shut downs. A major policy reversal in early January already. It does not inspire investor confidence domestically or internationally.
At the same time the Chinese yuan first hit a 4 year low and then by the middle of the week, it was down to a 5 year low. The Chinese government insisted that this was allowing market forces to ultimately determine the currency valuation. Although there are some experts that surmise it is yet another attempt, to make Chinese exports cheaper and therefore more competitive again. Just another way to try to stimulate the domestic economy.
By the second week of trading the PBOC (People’s Bank of China) was attempting to guide the yuan higher, as it had dropped further than might have been intended. This intervention called into question once again, the ability of Chinese bankers and regulators in handling the financial turmoil that was occurring. Others pundits were speculating what would happen in a real financial emergency, since there seems to be a lack of consensus on the part of the government in what direction to take.
The lack of a clear direction is resulting in major capital outflows, as investors lose confidence in the Chinese market. The rapid exchange rate depreciation, creates further uncertainty that is only accelerating the asset sell offs that has been in play since the beginning of the year. The precariousness of the system may not stifle all economic growth inside China, but it is creating havoc elsewhere as markets around the world respond to these circumstances.
Unlike in the West, large parts of the Chinese economy operates independently of the country’s stock markets. Overall, relatively few citizenry are heavily involved in stock purchases and sales. A much larger proportion of the new middle class, has instead invested in real estate, another distorted sector of the larger Chinese economy.
Nonetheless, the market is having an increasing negative sentiment on investment overall. Individual investors are still looking to sell their holdings, despite the heavy state buying. It explains why the Shanghai Composite dropped another 5.3%, at the beginning of the second week of trading for 2016. It is down a total of 15% for the year already. The Shenzhen Index dropped an additional 6.6%.
Deflation is becoming a concern inside China as well. Evidence suggests that factory-gate prices are continuing to fall. This has been a pattern for 46 straight consecutive months. Overall inflation was only 1.6% in December, compared to a year ago. It had only increased 0.1% from the previous month. It is hard to see any real change in this situation, as the global demand for Chinese goods continues to slacken.
The question for many investors is, what can China do to stimulate growth back to the stated annual goal rate of 7%? Further cuts to interest rates are likely, as are lowering the total amount of reserves banks are required to hold. However, it must be pointed out that the ability of central banks around the world and in China, to use monetary policy as a tool for growth, seems to be waning.
China still has a relative high rate of interest at 4.35%, in comparison to most other major economies of the world. The benchmark was cut by 25 basis points, the last time in October. Reserve requirements for banks were also lowered then. The temptation of the government will be to use this method of stimulus, as it is the least painful option available.
A number of analysts feel that further government spending to prop up the domestic economy is less likely, given the amount of debt that has been accumulating over the past few years. The country has amassed a record $28 trillion USD in private and public debt. It is estimated that borrowing has quadrupled in the last 7 years alone. Again, no one is really sure because the government will not release the true figures.
Total borrowing is thought to be over 300% of GDP (Gross Domestic Product). It increased from 158% in 2007 to 282% by the middle of 2014. It is the fastest increase in any major emerging market and double the rate of many developed countries, examples being the United States and the United Kingdom.
The old standby of propping up borrowers to prevent defaults leaves the economy mired in debt and only ensure years of stagnation and low productivity. It allows bankrupt businesses and companies to continue to function, when they are no longer profitable. This results in an unbalanced and a lower general growth rate. It smothers innovation and healthy competition in the larger economy.
All the recent new lending, makes it difficult to determine the percentage of loans that are in arrears. The many ambiguities and widespread shadow banking practices, make a true assessment even more challenging. There is also no way of really knowing how much of the debt is covered by entities of the government. Local and regional governments have borrowed in excess of $4 trillion USD alone. Many of the resulting infrastructure and real estate projects thus funded, were done independent of official balance sheet borrowing.
Slower growth and lower inflation will make the massive debt accumulated, much harder to service and to ever repay. One must anticipate that the heady growth pattern in the Chinese economy, is now a thing of the past. It will be difficult for investors to really gauge the true economic and financial picture inside China. This situation is unlikely to change as long as the authoritarian and undemocratic government continues to manipulate data, for the benefit of the present leadership.