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How deep do the Cracks Run in the Chinese Economy?

The Chinese government has been working hard behind the scenes to prop up the economy in the wake of disastrous stock market performance in August. Black Monday saw a reputed 8.5% of the value of Chinese equities on the Shanghai Composite index wiped out, spurring global panic as talk of an equities meltdown pervaded Wall Street, London, Paris and beyond. Wall Street plunged over 600 points and most every other market lost at least 3% - 4% on the day. But the tumult in global markets proved short-lived, while China is still licking its wounds today.

This begs the question: How deep do the cracks run in the Chinese economy?

For starters, the issues plaguing the Chinese economy are complex in nature. The Chinese have been implementing a strategic plan to convert their export-driven economy into a domestic consumer-oriented economy. This can be seen with massive infrastructure expenditure throughout China where ghost cities have been built to accommodate the tens of millions of people that are expected to move from agrarian/subsistence life to industrial life. While these cities are largely vacant across China and the expenditure appears to have had no noticeable economic boom effect, the long-term viability is sound.

Chinese Exposure to Equities Limited

The real issue however is market perception vis-a-vis the equities meltdown in the country. It should be noted that household exposure to equities markets in China is at maximum 15%. This pales in comparison to the USA where most every working person has a 401(k) which invests in stocks, mutual funds and other types of equities on the NASDAQ and Dow Jones Industrial Average, among others. If the equivalent 8.5% decline took place in US markets, the impact would be crushing. The Chinese economic juggernaut has a global reach, and China has its hands in the economies of most every country in the world. That it is the world’s second-largest economy is an important point to make. China has an insatiable appetite for raw materials, energy resources and other commodities.

On that fateful day – Black Monday – all the chickens came home to roost. The bubble had burst and China was front and centre of the world’s financial news. In an attempt to allay fears, the Chinese implemented a series of measures to prevent further declines in equities markets. These included a six-month moratorium on the sale of stocks with anyone holding 5% or more interest in a company, the establishment of a massive fund to purchase equities to prop up the markets, a 2% devaluation of the CNY, easing of regulations with regards to purchasing stocks, targeting banks and other rogue financial institutions, pinning the blame on a financial analyst et al.

Unprecedented Forex Sales to Prop up Yuan

But the most important action undertaken by China and the People’s Bank of China in particular was the sale of foreign currency reserves. Over the past several decades, China has enjoyed a massive balance of trade surplus, collecting stockpiles of foreign currency. During the month of August, panic crept into the markets and the Chinese did not want their currency to depreciate further, owing to capital flight, loss of confidence and foreign market avoidance of Chinese mutual funds and stocks. The Chinese spent $93.9 billion in August to prop up their currency. This marks the largest foreign currency decline in a month ever for China. China allows a 2 percentage point up/down variation in the value of the CNY on a daily basis. Analysts are of the opinion that if China continues to sell foreign currency reserves to keep the yuan at a stable level, it could deplete up to 14% of its holdings of forex by the end of the year. Additionally, the PBOC would need to reduce the amount of foreign exchange that banks are required to hold by as much as 40 basis points every month in order to keep up with the sale of forex reserves.

By the beginning of September 2015, the FX reserves in China plunged 2.6% from the July close. Net foreign assets owned by the People’s Bank of China are now sitting at $3.557 trillion. While substantial by anyone’s mission, the declines have caused a degree of concern among economic analysts. The problem in China is compounded by several other factors working in tandem with the sale of foreign currency reserves. For starters the September 16-17 meeting of the FOMC is likely to yield a decision about increasing interest rates in the US. Should this happen, it will accelerate the sale of foreign currencies in favour of purchasing the greenback. China is also battling ‘rogue’ banks and other financial institutions that are facilitating the transfer of unprecedented sums of capital out of the country. Law restricts individuals to just $50,000 per annum of capital transfers out of the country. China is now facing a contraction in market liquidity and there is a preponderance of evidence to suggest that the currency is being artificially maintained at higher levels.

Chinese Exporters Benefit from Currency Weakness

For their part, the Chinese have been touting their successful yuan stabilisation policy. At a recent meeting in Turkey, the central bank governor of the PBOC expressed confidence that all necessary steps had been taken to correct all imbalances that resulted in the market meltdown. The central bank governor believes that stability is on the horizon now that policy decisions have been enacted. It should be pointed out that equity markets in China have plunged 40% since their mid-June high, in spite of all the measures adopted by China to arrest the freefall. Further stimulus measures in the form of government expenditure are going to take place, with 10% expected for the current year. The Chinese economy is slated to grow at 7% for 2015, its lowest level in 25 years. Presently 1 Chinese yuan is the equivalent of $0.16, or alternatively $1 is the equivalent of 6.3676 CNY. The 52-week high for the USD/CNY currency pair is 6.4489. Clearly the market shocks have impacted on China in a big way, but exporters certainly aren’t complaining.

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