CHINA CONTAGION. CIO White Paper by David B. Pinkerton August 2015

Transcription

1 CHINA CONTAGION CIO White Paper by David B. Pinkerton August 2 Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

2 AUGUST 2 HAS CHINA CONTAGION RISK INCREASED? INTRODUCTION In a CIO White Paper last year, we analysed the question, whether the sell-off in emerging market equities at the beginning of last year would spill-over to developed markets. We looked at past emerging market crises, such as the great depression in Argentina and the Russian default. We found that developed equity markets were only affected temporarily and modestly, and that there was no material adverse effect on developed markets (DM). We then took a closer look at China and asked ourselves the same question: is the slowdown in the Chinese economy or a hard landing having a material impact on DM economies and stock markets? We concluded that the slowdown would not present longer term systematic spillover risk to the US economy or US equity markets at this time. The following table summarises our assessment and the rationale behind it. WHAT DID WE SAY LAST YEAR? Chinese economy is not likely to have a longer term material adverse effect on the US economy. Deceleration in China will potentially and more materially affect the suppliers to China, mainly emerging market raw material providers. Emerging market contagion risk is limited to other emerging markets. WHY DID WE SAY THAT? Deceleration and bursting of bubble in Japan in did not materially affect the US. Japan s economy was larger globally at the time relative to the percentage that China is today. Moreover, the bubble popping in Japan did not adversely affect the US equity market longer term. In fact, the price cutting of Japanese goods and a weakening of the Japanese yen made these goods less expensive for the American consumer and in effect supported US GDP growth. We observed that the previous build-up of Chinese hard infrastructure with its heavy raw material consumption like iron ore, steel etc., was a major contributor to the commodity bull market that lasted up through the 2 financial crisis. Since then, the Chinese economy has been sustaining a top line growth of around % p.a., but its composition is changing to less of an emphasis on hard infrastructure and exports and more of an emphasis on soft infrastructure like (healthcare, education, environmental issues and IT related industries). All of these industries are less consumptive of raw materials, which adds more to the pressure on commodity prices in general. Examples: consumer durable companies and other companies with recession resilient earnings (boring products). Source: Falcon Private Bank. Are we there yet? Are these presumptions that we made about a year ago still valid or is it possible that global risk sentiment is likely to be more adversely affected, given that the sentiment around Greece seemed to be quite dramatic? Is the slowdown of the Chinese economy a more material threat now than it was last year? Is the recent stock market decline likely to reflect more directly on the Chinese economy and will this raise the level of significance on the overall global growth levels? Cycle of credit creation To understand how this puzzle of moving parts fits into the global puzzle, a simple illustration is useful. All economies and their stock markets are reflexive in nature, meaning that economies and stock markets are interdependent. Stock market valuations reflect actual health and perceived future health of the underlying economy. As a reminder, capital markets are principally affected by marginal liquidity and credit creation. This emanates first in monetary policy and credit creation at the central bank level. Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

3 AUGUST 2 The cycle of credit creation and its impact on financial asset valuations and economic vitality is illustrated below. NPLs up, restructuring happens Earnings down, economy slows Source: Falcon Private Bank. Economic contraction Equities in bear market Stimulus reversed, rates up Stimulus, lower rates, credit expands Economic expansion Equities in bull market Capacity expands, wages up, inflation emerges Currency depreciates, exports expand GDP up, debt up, earnings up In order to examine the impact of the stock market decline to the local economy, we looked at the stock market capitalisation relative to GDP. This allows us to examine the wealth effect that occurred due to the loss of equity market capital. China s independent stock market The Chinese stock market has become the world s second largest after the US, overtaking Japan. However, the stock market capitalisation as a percentage of GDP is still relatively small in China (%), compared to e.g. the US (4%) and Japan (%). The development of total market capitalisation compared to GDP is illustrated in the following chart. The equity market in China has played a much more significant role during the bull market in 26 and 2, where total market capitalisation was 6% of GDP. Thereafter, the share in GDP was declining, until it began to grow again in the recent bull market. Stock market capitalisation to GDP US Japan China The stock market in China is therefore relatively less important to Chinese companies and has fewer linkages to the economy. It is estimated that no more than % of total household assets are invested in equities, making losses in the equity market less of a concern. A potential wealth effect caused by the recent stock market plunge will therefore be limited. This is supported by the observation that the 2-month rally preceding the recent plunge did not trigger a boost in consumption. Unlike consumers from developed countries, the Chinese tend to save the majority of their income, making consumption less sensitive to changes in overall wealth. However, one must be aware that the increase in margin trading, which was built up during the rally, can cause potential risk. This was what mainly forced liquidations of assets triggered by margin calls, leading to a downward spiral. The interventions taken by the Chinese government have shown that they are willing to do whatever it takes in order to prevent equity prices from further losses. One reason for the Chinese government to support equities from falling and trying to make them less volatile, is that they aim for an equity market that is more accessible to international investors and a more common source of financing for Chinese firms. By losing the reputation of having a casino-like stock market, China could attract a broader investor base and increase the share of institutional investors, eventually making it more linked to the economy. CHINA S IMPORTANCE IN A GLOBAL CONTEXT Economy China has been among the world s fastest growing economies since the economy has been opened up for foreign trade and investment in. The country has repeatedly reported double digit economic growth, thereby increased economic output from USD bn in, to USD. tr in 24. China has emerged as a major economic power, now being the second largest economy after the US (but the largest on a purchasing power parity basis). The high-growth model has been possible mainly through a focus on exports and fixed investments. However, the global economic crisis in 2 has affected the Chinese economy and weak global demand has led to slower growth. A USD 6 bn stimulus program by the Chinese government helped the economy to withstand the fall in global demand. Despite the stimulus, economic growth has slowed since then. The following chart illustrates that real GDP in China fell from.4% in 2 to.4% in 24. China real GDP (%, YoY) Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

4 AUGUST 2 Despite the slowdown of the economy, China s share of world GDP (adjusted for purchasing power parity) has increased to %, whereas the share of the US economy has been continuously decreasing (see chart below). This implies that even with slowing growth, China s economy will grow faster than that of the US and the rest of the developed world. China is therefore increasing its share in global GDP, while the world share of developed countries is shrinking. The International Monetary Fund (IMF) estimates that economic growth in China will come down to as much as 6.% by 26. Even though there is a broad consensus that China cannot maintain the high growth rates from the last decades, long term growth in China depends heavily on the ability of the government to rebalance its economy to a more consumption driven one. GDP share of world * % % % dropped during the crisis. However, growth rates have been decreasing since then and even turned negative. This is in line with overall economic growth, which was increasing before the financial crisis, but decreasing thereafter. EBITDA per share (USD) Shanghai Shenzhen (% of world ) % 6% % 4% % 2% % % Source: IMF. * Purchasing Price Parity. Others France UK Germany Japan Slowing growth in China is a major concern globally. Whether or not the growth data published by the Chinese government are reliable is another concern. Some argue that real GDP numbers are overstated, using erroneous deflators. Looking at profitability measures of Chinese companies, we find that figures are in line with real GDP growth data, implying that government statistics are reliable. Sales per share (USD) 6 China Shenzhen Shanghai Sales per share increased overproportionally until 2, then declined, grew again - but at a slower pace - and are now decreasing again. The same is true for EBITDA, which started to decrease in 24. The results show that corporate sales and profits were growing fast before the financial crisis and showed a rebound after the numbers 2 US Economic transition We have stated that China s future economic growth depends on the government s ability to push reforms forward in order accelerate the process of rebalancing the economy. The rapid economic growth over the last three decades has mainly been driven by surging investment and exploding exports, but less by household consumption. The ongoing economic slowdown suggests that this model of economic growth is running out of steam. This led the Chinese government to rethink the country s growth, thereby aiming to achieve more sustainable growth driven by domestic consumption. The chart below shows the development of GDP components. While household consumption has been falling in the last decade, private investment has increased. This suggests that China has not made much progress yet in transforming its economy. But it seems that consumption is slowly picking up, on costs of private investment. Considering that the GDP share of consumption expenditure is still relatively low compared to most developed countries (6% in the US), it is reasonable to say that China is far from being a consumption-driven economy. GDP components Net Exports Investment Consumption Net Exports Investment Consumption Net Exports Investment Consumption Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

5 AUGUST 2 Trade ties GDP rebalancing will have major consequences for China s trading partners. In order to make any assumptions about rebalancing effects for foreign countries, it is therefore necessary to analyse China s trade ties. China is overall running a trade surplus. Its biggest trading partner is the US, with whom China is running a trade surplus of USD bn (24). However, exports to China only make up a small portion of total US exports. A slowing Chinese economy will therefore not have a material adverse effect on the overall US economy. This is different for commodity exporters, such as Australia, Brazil, Russia or South Korea, who are heavily dependent on Chinese trade. To give an idea of the scope, GDP growth in Brazil has dropped from 2.% in 2 to.% in 24. Whereas this drop is certainly also caused by other factors than just lower exports to China, it shows that countries with heavy links to China are more vulnerable in times of low demand and decreasing commodity prices. China is the world s largest importer of copper, aluminum and cotton and is the biggest trading partner for countries like Australia, Brazil, Indonesia, South Korea and South Africa. China s transition to a more consumption and service led economy 2will further put pressure on 2 GDP growth in these countries. We will further analyse potential consequences for 2 2 trading partners in a section below. technologies. This plan consists of a restructuring of the manufacturing sector, aiming to remove overcapacity, which exists in some of the sectors. Furthermore, this plan calls for financial support for new sectors, e.g. IT, aerospace, medicine and medical devices, as well as institutional reforms. Hence, we do not think that the slowing of the manufacturing represents a material threat at this point. Debt structure and liability China has accumulated a substantial stock of debt over the last decade. Total debt amounts 22% of GDP in 24, up from 2% in 2. Compared to advanced economies such as the US (26% in 24), Germany (2%) or Australia (24%) the total debt level is higher in China. Absolute total debt has increased from USD 2. tr in 2 to USD 2.2 tr in 24. The largest component of this growth has been due to increased borrowing by non-financial corporations, including property firms. China debt to GDP Stimulus measures The government has taken various measures to spur growth. The 2 benchmark interest rate has been lowered three times since November 24, from 6% to 4.%. In addition, the government has lowered the reserve ratio for banks twice this year, allowing banks to lend more money. As inflation is decreasing (.4% YoY) and is at a lower level than the target (.% YoY), there is still more room for the government to lower interest rates. The efficacy of lowering interest rates can be measured by the growth in the broader money supply. Money supply has been increasing over the last three months, indicating that the stimulus measures are showing first signs of support. CHINA S WEAK LINKS AND RISKS There are three factors of the Chinese economy that used to be the drivers of the double digit growth, but now turned to weak links. These are the manufacturing sector, China s debt structure and the real estate and property market. In this section, we analyse these three factors. Manufacturing (Q2) (Q2) 2 24 (Q2) 2 24 (Q2) Government Non-financial corporategovernment Financial institutions Non-financial Government Households corporate Financial Non-financial Government institutions corporatenon-financial Households Financial institutions corporate Financial Government Households institutions Non-financial Househ co Manufacturing has been an important pillar of China s growth over the past decades. China s manufacturing industry has been slowing in the process of rebalancing the economy away from exports to consumption. However, China s share of global manufacturing output has grown to 2%, compared to % in, and has constantly contributed about 2% to GDP. China still has a comparative advantage due to low-cost manufacturing. As noted above, personal consumption has been increasing slowly, leading to stronger demand from domestic consumers. The made in China 2 plan initiated by the Premier in May 2 aims to promote manufacturing and sets the path for China to become the leader in manufacturing innovative The question is, whether the current debt level can be sustained or if it is leading to a financials meltdown. Shadow banking accounts for % of total loans outstanding and represents a risk for China s financial stability. A collapse in the property market would be damaging to China s further growth. By international standards, % of government debt to GDP is relatively low and the Chinese government has the tools and the capacity to bail out the financial sector. In addition, China s vast foreign currency reserves, which were about USD 4 tr in 24, would be enough to prevent a collapse of the financial system. A large part of the credit expansion has been related to the real estate sector. In order to boost the economy when the financial crisis hit the global economies, local governments spent substantial amounts in infrastructure and piled up debt in the process. This used to be a significant growth factor. In the following section, we analyse the Chinese real estate and property market in more detail. Real estate and property market In the 2-2 period, Chinese local governments carried out massive infrastructure investments to counter the impact of the crisis and to stimulate the economy. New construction has grown rapidly and prices have risen substantially. But a major change in the government spending policy has led to a slowdown in construction. The Chinese real estate and property market has been a major Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

6 AUGUST 2 source of concern. Building sales and prices fell significantly in 24. With a combined weight of % of GDP, the construction and real estate sector has a significant impact. Lately, China s housing market has shown signs of recovery. The residential property market has continued to recover over the last few months, with residential building prices rising and sales of new buildings increasing (see chart below). Other segments of the economy, such as construction, furniture and other consumer goods, will indirectly benefit as a result. Total sales of buildings Residential building prices First Tier Cities Second Tier Cities Third Tier Cities Note: first Tier Cities include Shanghai, Beijing, Shenzhen and Guangzhou. IMPLICATIONS FOR CHINA S FUTURE AND GLOBAL GROWTH Less dependence on foreign trade As we established earlier, China s GDP is now a more material component of the world economy than it was a decade ago. In the process of becoming the world s second largest economy, international trade has intensified. In 24, total trade amounted to USD 4. tr compared to USD.6 tr, ten years earlier. Continuous economic reforms and free trade agreements have been positive catalysts for an increased trade volume. However, as China s exports and imports intensified in absolute terms, growth rates have been gradually decreasing since the financial crisis. Because foreign trade grew less than the overall economy, the share of exports and imports of GDP became smaller. Chinese foreign trade (USD bn) 2' 2' ' ' Exports Imports Net exports The chart above shows exports and imports from and to China (in USD). Since exports have always been larger than imports, China has been a net exporting country. In absolute terms, both exports and imports have been increasing most of the time (with the exception of the financial crisis). However, the gap between exports and imports has been widening in recent years, suggesting that China s demand from other countries is slowing. Apart from the widening gap, it can clearly be seen that both exports and imports are slowing down. We have examined growth rates of exports and imports and illustrated the results in the following chart. It shows that although growth rates are still positive, they are decreasing, with imports shortly reaching the zero growth line. This implies that the financial crisis has had major consequences for international trade. Low global demand has decreased the pace by which China can export and import its goods and services. Growth rates for Chinese exports and imports Exports Imports The slowdown of foreign trade caused the share in GDP to decrease over the last five years. Whereas exports made up more than % of GDP in 26, it is now getting close to 2%. A similar development can be observed in imports. The chart below illustrates these observations. Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

7 AUGUST 2 Share of foreign trade in GDP Main goods imported into China (24) Exports Imports Crude oil Iron ore Plastics in primary forms Soybean Copper and copper alloys Refined oil products Coal (incl. lignite) Rolled steel Paper pulp Cereals and cereal flour Edible vegetable oil Aluminum oxide Source: ' '2 '4 '6 (CNY bn) What we can conclude is that since the financial crisis, China s foreign trade has seen a major slowdown. Also, the importance of China s exports has been somewhat diminishing. Whereas exports were a major driver of China s growth before 2, it was the huge amounts of investments that contributed to GDP growth in the aftermath of the financial crisis. The following chart shows the drivers of GDP growth. Whereas positive net exports contributed significantly to China s double digit growth rates from 2 to 2, it was negative net exports that dragged economic growth down from 2 to 2. GDP growth and contributions to growth As China s imports have been slowing since the financial crisis, commodity oriented countries that are highly exposed to China are facing an economic slowdown, which can partly be explained by China s reduced demand. The following charts illustrate the trade dependency of Australia and Brazil on China. These two countries depend heavily on exports to China: Australia ships 4% of total exports to China and Brazil ships 2% to China. The charts show that there is a relationship between exports and GDP. While export growth to China started to decrease after 2, both countries GDP growth went in the same direction. Clearly, there have been other factors contributing to these countries GDP slowdown, but considering the significance of the exposure to China, one cannot neglect these parallels. Australia exports to China and GDP estment Consumption Net Exports GDP Consumption Investment Growth Consumption Net Investment Exports Investment GDP Net Growth Exports Net Consumption GDP Exports Growth -2 GDP Investment Growth Net Exports GDP Growth Pressure on commodity oriented countries Whereas most of Chinese exports consist of manufactured goods, most of which are textiles and electronic equipment, imports are heavily commodity oriented. The following chart shows the main goods imported by China in 24, with crude oil being the number one imported good. Exports to China (LH) GDP Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax

8 AUGUST 2 Brazil exports to China and GDP Exports to China (LH) Another factor to consider is the impact of China s slowing imports and falling commodity prices on emerging market currencies. Emerging market currencies have fallen to -year lows. The Brazilian real has been hit the hardest this year and has depreciated more than 2% versus the dollar. Whereas depreciating currencies make exports more competitive, it also increases import prices and the cost of servicing debt in denominated foreign currencies. Overall, we think that the pressure on emerging market currencies will continue to contribute to slow investor appetite toward emerging equity markets. GDP SUMMARY AND CONCLUSION China s slowdown has gained much attention and sparked worries globally about potential spill-over effects to developed countries and other emerging countries. Given the increased volatility in Chinese equity markets over the last few weeks and months, we decided to look at the state of the Chinese economy more closely. The government has realised that the country has to rebalance its economy away from a focus on exports and investments to a focus on consumption. This process has already been started, given that exports and imports are now a much smaller part of overall economic output. But it was largely due to the shrinking exports, that GDP growth is slowing. The slowing demand for commodities has affected growth for commodity exporting countries and put pressure on commodity prices. We think that weak demand will continue to keep commodity prices low. However, we also believe that the major part of the slowdown has already taken place and therefore, the impact on growth of commodity exporting countries should be limited. China s future growth rate depends on the ability of China to successfully push through important reforms, in order for the rebalancing process to accelerate. First signs show that consumption is overtaking investment as the major contribution to GDP growth and it is likely that this trend is going to persist. Considering that China s GDP has already slowed down from 4% to % within years, we think that a further slowdown to about % will not have a major impact globally. DISCLAIMER This CIO White Paper is published by the CIO Office of Falcon Private Bank Ltd., Zurich. This document has been prepared solely for information purposes and for the use of the recipient. It represents the personal opinion of the author, CIO David Pinkerton, as of the date cited and may change at any time and it does not necessarily represent the view of Falcon Private Bank Ltd. The distribution of this document as well as certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but we make no representations or warranties, expressed or implied, as to its completeness and accuracy. Opinions do not imply recommendation. Certain information may contain forecasts, prognosis and other future statements; they do not represent any actual result and are mainly based on theoretical assumptions, which are retroactively applied on historical financial information. Forecasts and estimates are current only as of the date of this publication and may change without notice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Any transaction should be considered only if you are fully aware of the risks involved and are in a position to bear any financial losses. Before making any investment decisions, you should consult your own financial, legal, business, tax and other advisors. The development of the values mentioned in this document originates in the past. Past performance is no guarantee for future performance. The information used in this document has been provided as a general market commentary only and does not constitute an offer of or an invitation to any person to buy or sell any product, or make any kind of investment. CIO Office Falcon Private Bank 2. All rights reserved. Falcon Private Bank Ltd. Pelikanstrasse P.O. Box 6 2 Zurich, Switzerland Phone Fax