Over the last few weeks and months huge amount of media has been generated on this topic where lot of arm chair economists are using some ratios of credit to GDP, fixed capital formation and fuzzy data on the wealth management products in China in order to forecast that China is going to collapse and create a huge crisis in the world.
Now I will try to keep this article brief and simple to understand. It is true that China has sustained high growth due to two major factors; exports and fixed capital formation. It is also true that lot of the fixed capital formation which includes investment in marquee infrastructure projects cannot be justified in purely commercial terms. As such these combined with the non transparent wealth management products have created a crisis of sorts in China. The main reason for the emergence of these wealth management products in China and also the huge spurt in consumption and investment into gold has been due to the extremely low interest rates paid by the banks in China where the rates are regulated down to extremely low levels.
There are also issues related to the bank balance sheets in China where it is believed that these banks need to raise a huge amount of capital in order to sustain the kind of credit growth that is happening in China. It is also true that the banks will find it difficult to raise such huge amounts of capital if they propose to expand the balance sheet in the same manner as they have been expanding over the last decade. The next level of concerns come on the health of the provincial governments which have gone on a huge budgetary spending binge in order to outdo each other in term of growth. This has raised question marks on their balance sheets.
Now despite all of these it is highly unlikely that an implosion is imminent in China. While the probability that the Chinese economy will slow down significantly from the levels seen over the last 10 years, an economic crisis is highly unlikely. The reasons are simple and are as follows.
The Forex Reserves- The foreign exchange reserves of China are the highest in the world. At a level of $3.8 trillion is more than three times that of the next country in the list. Such huge foreign exchange reserves are a huge cushion against any crisis that unfolds internally as this money is theirs and can be used to address any crisis.
Sustained trade surplus despite a huge relative appreciation- China has sustained huge trade surpluses despite a huge relative appreciation of the Yuan. The Yuan has been stable to appreciating right through the entire emerging market currency crisis. Even in the Non Deliverable Forwards (NDF) markets the Chinese currency has been very stable. There has been no huge outflow of money out of China and most foreign investors have stayed put. This reflects confidence in the Chinese currency and Chinese assets and does not support the theory of any imminent crisis in China.
A high savings rate- China has a savings rate which exceeds 50% of GDP and is by far the highest in the world. The investment rate in China is also the highest in the world and has stood around 5% below the savings rate over a long period of time. This shows all the investment in the economy can be funded out of domestic savings. With such a huge domestic saving rate it is unlikely there will be any big crisis in the near term.
A sustained low inflation- Inflation in China has sustained low single digits for long period of time. This has been despite runaway credit growth which would normally lead to inflationary pressures. China has kept on increasing supplies at a brisk pace to keep pace with demand unlike in India where the supply response has always been missing and any uptick in demand leads to a spike in inflation. A strong supply response is positive for the economy. However excessive supplies lead to losses and pressure on bank and corporate balance sheets. This is something that China is experiencing today.
A strong Fiscal Position of the Central Government- Over the last 10 years China has had a Budget Deficit which has averaged around 1.5% of GDP and the Government Debt to GDP stands at just 26% which is one of the lowest among large economies of the world. As such both on the current account and the fiscal account China are very well positioned. Any losses from provincial governments or due to the wealth management products of State owned banks can easily be funded via the budget by the Chinese government if push comes to shove.
In conclusion, my advice to everyone will be that do not believe the doomsday forecasts being put out by analysts on China. There might yet be a crisis in China but not in the next few years.
MARKETS
Stock markets all over the world and more so in Emerging Markets have corrected since the beginning of the year due to fears about the next round of currency crisis as well as concerns on China. This has led to huge outflows from Equity Funds. Emerging Market Equtiy Funds lost $ 18 billion since the beginning of the year as against $ 15.6 billion for the entire year 2013. Valuations have come down to reasonable levels and 15 straight weeks of outflows is a record with the previous record being at 14 weeks of outflows in the year 2002. This is a perfect contrarian indicator for a market bottom. The CBOE Volatility Index also touched a bull market high of 23-24 last week and has corrected subsequently.
Markets might still correct somewhat but a big downside looks unlikely and the worst of the EM selloff seems to be behind us. A preelection rally in India is also imminent. Overall markets look constructive for the near to medium term.