Some say China’s credit boom will perpetuate a collapse in its debt markets, the yuan, and its stock market. This misses the mark. China has the critical tools necessary to engineer a "soft landing" and slow the country's economic growth.
While we disagree with the China doomsday scenario, slowing growth will undoubtedly hurt the country’s stock market. We suggest investors short Chinese large-cap stocks (FXI).
Setting aside China’s phony GDP data, their economy is clearly slowing. The chart below shows the breakdown of China’s growth by sub-industries. The recent “recovery” in 2016 was predicated on the growth rate of heavy industry.
It's unlikely this growth in heavy industry repeats itself. It was perpetuated by a significant amount of fiscal and monetary stimulus.
In January 2015, the People’s Bank of China pumped 1.235 trillion yuan into the economy. This January, it was a mere 350 billion, a -72% decline. A centrally planned slowdown of this magnitude has never been attempted before in modern economic history. While we’re not calling for collapse, it is safe to assume the glide path down will be less linear than Beijing hopes.
Currently, China is experiencing a financial crisis with communist characteristics. While China may eventually accomplish their twin goals of permanently downshifting GDP growth and rebalancing economic drivers, their insistence upon maintaining financial and economic stability throughout effectively transfers deflation risk from the market in the near term to the real economy over the longer term.
Instead of boom turned bust, policymakers will continue throwing cold water on the economy, specifically the overheated property market.
China Won't Collapse
China’s economy has a closed capital account, which essentially means companies, banks and individuals can’t move substantial amounts of money in or out of the country without bumping up against the government’s stringent rules and regulations.
This largely explains away the possibility of material currency devaluation in China. Comparing China to the 25 other emerging markets we track across a variety of metrics reveals some interesting insights:
- Short-Term External Debt (as a percentage of total foreign direct investment) is a proxy for how much money China needs to pay back to foreigners. It’s only 10% versus about 19% for other emerging markets.
- Inbound Portfolio Investment is the biggest culprit for short-term, large currency fluctuations. On that measure, China has a lowly 3% relative to 16% for the average of other Emerging Markets.
- Dollar-Denominated Debt (as a percentage of foreign exchange reserves) is only about 35% versus 100% for the average of most other emerging market economies.
We believe that Beijing has the critical tools necessary to engineer a “soft landing” and slow the country’s economic growth. While a soft landing is not a face-plant for the Chinese economy, slowing growth will hurt the country’s stock market. Steer clear of Chinese large-cap stocks.