China - Fundamental Weakness, Or Just Noise?

By Adam Stanley - February 2, 2016

Bears in the investment community have long been warning of a China collapse, and the latest stock market volatility has emboldened their doom and gloom predictions.

But how much do we need to worry about the Chinese market? Is it ripe for wholesale collapse or is the current situation more reflective of a storm in a teacup?

The answer lies with whether current market volatility is reflective of fundamental weaknesses in the Chinese economy. The current stock market rout has outlined that, like any economy and particularly one under such a historically high degree of government control, China’s authorities will face challenges as markets mature.

The bears among the analysts are certainly pushing the line that the yuan devaluation against the US dollar shows that China has lost control of its currency and its ability to formulate policy responses to regain control of their markets.

Investment bears are further keen to make the case that the Chinese economy is in much worse shape than the government is letting on, and that this current slide marks the beginning of a mass exodus of capital from the Chinese market as the smart money on the ground gets out.

But market volatility is to be expected as the economy – slowly, painfully – liberalises and transitions away from a manufacturing and infrastructure-based model into more consumption-led drivers of growth.

China’s slowing GDP growth has been reflecting this shift for several years, and more optimistically, it’s worth noting that although manufacturing has slowed in China, it has been maintaining realistic growth levels for some time. Bearish analysts also seem to have lost sight of the fact that China’s services sector continues to grow strongly.

Hedge funds are shorting Chinese exchange traded funds, and also shorting Australian stocks due to our exposure to Chinese markets.

China’s markets are of course still subject to significant government control, and as such there remains a likelihood of the Chinese government announcing some easing program, causing the Chinese market to rise dramatically – catching out hedge funds. That kind of market interference won’t happen in Australia, making Australian stocks a safer bet for avid short sellers.

It’s worth remembering as well that everyone is pointing to the yuan’s depreciation versus the US dollar, however in mid-December the Chinese announced a new basket of currencies that it advised the market it should consider when deciding if the Yuan was overvalued or not. 

Essentially China are saying that they will not be pegged to the US dollar – movements in the yuan will be more dependent upon movements in this new trade-weighted basket of 13 currencies. And certainly, looking at how the yuan has traded versus the basket shows a more stable picture than the USD equivalent. 

But Chinese authorities have not helped the current crisis; they did not clearly communicate the move towards a trade-weighted basket, and they have refused to confirm the yuan will now be pegged to the basket instead of a USD equivalent. 

And the current slide was triggered by another poor piece of intervention on the part of the Chinese government. ‘Circuit breakers’ designed to provide market participants with some breathing space simply provided a target to the downside for the market to hit. The trigger was a 7% fall in any one day, resulting in a bourse shut-down for 24 hours – a provision that has since been removed due to its negative signalling effects.

About all that is clear about the current correction is that the Chinese economy is undergoing a structural readjustment as it matures into a consumption-led economy and out of manufacturing and there aren’t any quick fixes to the China problem.

This might be cold comfort for Australian investors feeling the pinch at the moment, but at the end of the day, it’s wisest to consider the words of Federal Reserve Bank of Atlanta President Dennis Lockhart: “when such volatility [in international markets] develops…it is helpful to look at the real economy and ask if something is fundamentally wrong”.

And it’s certainly not evident that the Chinese market volatility has a causative root in real economic weakness, as opposed to noise created by opportunistic short-selling, evolving markets, and poor communication on the part of Chinese authorities. 

 


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