China's Potential Hard Landing
Amid the European economic mayhem, the only thing not in focus is China's potential 'hard landing'. This appears to have changed, as the debate has recently resurfaced.
What is a 'hard landing'?
Most economists would consider it to be an economy that is rapidly falling into recession, and according to Reuters, a hard landing often occurs when a government has aggressively tightened policy. However, while no one expects China to see two quarters of GDP contraction, growth below 7% will almost feel like recession to the country, and it is this level that many are concerned with.
Why it may occur
- Bank of America/Merrill Lynch (BOA/ML) head of China equity strategy, David Cui, recently released a presentation to clients about a potential 'hard landing' scenario; he is the number-one rated China strategist according to the 2011 Institutional Investor All-China Survey. Mr Cui predicated that a hard landing was probable, suggesting financial market stresses have increased dramatically, potentially being the trigger for sub-7% growth.
- Ratings agency Fitch's head of sovereign rating, Andrew Colquhoun, commented that in the near term, the biggest risk to China's sovereign rating is the banking sector. Credit default swaps of Chinese banks (OTC derivatives used by institutions to insure themselves in case of a default on a corporate or sovereign bond they may be holding) have widened significantly in recent times. This has occurred as banks have made significant loans, many to local governments and many using property and land as collateral; the worry being that if house and land prices fall, banks could be forced to book higher losses.
- The other main concern is global growth and how China would fare if the world slows down markedly. In 2008, Chinese exports contracted 27%, with GDP falling from 10% to 7% as most developed nations fell into recession. BOA/ML suggested that with every 1% slowdown in developed markets, GDP could result in a 5% decline in China's growth. This is the concern, and with China's biggest export partner, Europe, likely to go into a mild recession, the fear is China could be hurt as well.
The other side of the coin
While we acknowledge that there are risks, we believe a hard landing will probably be avoided. Goldman Sachs revised its house view of global growth in 2012 on October 4 to 3.5% (from 4.2%), plus its view on China to grow 8.6% (from 9.2%). This figure seems to be the consensus amongst the analyst community, after taking on board the stress in the financial system. The key thing we believe is that China's growth is much less reliant on exports nowadays, and this is fundamental to it avoiding a hard landing . According to HSBC, China's net exports to GDP ratio has shrunk to 2-3% from 8-9% before the global crisis, while interestingly, net exports made almost no contribution to China's 1H2011 growth of 9.6%. This, in theory, suggests that even if we do see a global recession, China would not be as badly affected as it was in 2008.
China also has a significant war chest, and will be keen to deploy it if it feels there is growing tension within its population, forcing its hand to stimulate the economy. While China has a significant amount on the monetary level it can do (cutting reserve ratio requirements to banks and interest rates), it seems analysts suggest the most likely policy response will be on a fiscal level, with the People's Bank of China targeting expansion in public housing or small- and medium-sized enterprises (SMEs), with the idea to create jobs and stimulate wealth.
China's housing market
We also feel China's housing market is not going to implode anytime soon. There are risks of course, and despite the government putting measures in place just over a year ago to curb speculation, it seems house prices have held up relatively well. Many have talked about 'ghost cities', with the Kangbashi district of Ordos (inner Mongolia) only 15% inhabited. However, with an estimated 310 million people expected to migrate from the country to the cities over the next 20 years, we feel this should mop up the excess we are seeing today.
The bottom line is we feel that fears over China seeing sub-7% growth based on global fears is overdone. There is great concern about SMEs, after a failure of a number of businesses in Wenzhou, and we are seeing an increasing number of businesses borrowing from non-bank sources at interest rates ranging from 20% to 180% because of credit tightening. There is a worry that further failures here could spread across the mainland, however we have faith that the PBOC has the long-term firepower to arrest this issue.
How it may affect local trading
- All in all, if you are still holding an Australian resource company, keep your eyes peeled on narrative from CEOs on whether they are seeing a slowdown in demand. Recent reports from Andrew Forest and Marius Kloppers have suggested that they were not seeing any deferred orders.
- Also, watch copper closely; it is perhaps one the purest reads on economic sentiment as well as the Shanghai Composite which has fallen 30% from its April high.
China in our mind has risks, but they are largely priced in now given the huge moves down that we have seen. We have confidence that the Chinese authorities are in control of domestic growth, and they are less reliant on external factors, so hopefully in the near term the idea of a hard landing can be put to bed.
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