Turbulence in Global Markets: Systemic Risks of a China Slowdown?

This article appears originally in the Daily Mirror Business of 27th August, under the ‘Smart Future’ column

“When China sneezes, does the world catch a cold?” is a question on the minds of investors, economists and world leaders this week, as recent troubles in the Chinese economy sent ripples through markets around the world. The sneezing came in three bouts. In July, China’s stock market began to show the first signs of stress, with the markets in Shanghai plunging and over 1000 listed companies suspending trading. Then in a sudden move in early August, the People’s Bank of China devalued the Yuan by the sharpest amount in two decades, leading investors to believe that China was facing severe weaknesses in exports. The final sneeze was just last week when a key manufacturing factory activity indicator – the Caixin-Markin Purchasing Managers Index (PMI) fell to its most pessimistic level since the global slowdown in 2009 – a 77-month low of 47.9 (PMI below 50 on the 100 point scale indicates a decline). All of mini-sneezes combined to send jitters across the global economy, and since Friday last week the global economy has been sniffling. The full-blown cold came on Monday – now dubbed ‘Black Monday’ where nearly all major markets saw declines not seen since the onset of the global finance crisis. The Shanghai Composite Index fell by 8.4% – the largest one-day drop since 2007 and continued a further decline of 7.6% on Tuesday. Meanwhile, the Hongkong HangSeng fell by 3.5%, Singapore Straits Times Index by 2.3%, Australia S&P/ASX 200 by 2.6% (steepest since May 2012), and the Dow Jones Index and NASDAQ in the US and the FTSE in the UK all down by more than 3%. The Dow fell by nearly 600 points after starting trading down over 1000 points. Many of the markets have since recovered somewhat, but continue to be volatile. Whether the cold goes away or develops into a full-blown flu’ remains to be seen.

Immediate Medicine

Chinese authorities have tried to stop the rout. After the initial stock market crash, they pumped in millions of Yuan to prop up the market. Last week, state pension funds were given permission to invest in stocks, in the hope that this would boost the market too. Yet, investors overseas found little comfort in these measures. It is only when on Tuesday this week, the PBoC moved to cut interest rates for the fifth time in 12 months, that markets finally began to respond positively. Moreover, the PBoC cut Reserve Ratio Requirements for banks, in the hope of further boosting liquidity.

Systemically Important

If it wasn’t clear already, this week’s rout is confirmation of how China’s growth fortunes are linked to the global economy more than ever before and the any weaknesses in the Chinese economy poses systemic risks. The Chinese economy now accounts for 15% of global GDP and around half of global growth. China’s insatiable appetite for commodities means that it now accounts for 25% of global steel demand, and determines the prices of copper, iron, and coal. Any slowdown in China would mean a slowdown in the global commodities trade, and hurt some countries harder than others. For Australia, one fourth of its exports are to China (mainly commodities). For South Africa, 45% of its exports are to China, mainly in platinum group metals, gold, coal, and iron ore. Fears are that a prolonged China slowdown would reduce demand for commodities like metals and oil. This is probably why, following ‘Black Monday’, commodities indices have fallen sharply. The major counters influencing the fall of the Dow in the past days have been the fall in stocks of mining, mineral and other commodities companies. More broadly, the Bloomberg Commodity Index has fallen to its lowest level in 16 years.

Chinese Reforms – Unconvinced or Unseen?

In an era of increased systemic risk from China, it seems that the global investment community is unconvinced of, or at least unsure of, what Chinese authorities are doing to stop the rout and stimulate growth. The most obvious move of cutting interest rates and reserve requirements seem to have had the most pronounced effect so far. Yet, investors are yet to see to what extent the more fundamental structural reforms are being done to ensure Chinese growth avoids a so-called ‘hard-landing’ and instead transitions into an era of rebalanced growth that is sustained over a longer period (and the government’s 7% target is actually achieved). In this, one cannot ignore important progress being made. For instance, last year the central government either cut or streamlined over 600 items of administrative and approvals processes to improve the business climate. Reforming SOEs to become more professionally managed, more globally competitive and less state-dependent is already underway. Innovation has become a strong focus, in order to move the economy away from a low cost model to a value creation one. Chinese universities are globalizing and Chinese researchers are publishing in international journals and filing more patents in the US than the US itself (250,000 in 2012). Over 100 universities now have innovation incubators to help young Chinese students commercialise their ideas, and in the past three years alone 100 universities in the country have started departments to research on the ‘Internet of Things’. So, writing off China’s growth prospects as “weak” in the light of recent volatility and turbulence might be premature.

Future Outlook

Yet, there is good reason for concern, if not for panic. It is fair that fundamental questions are being raised about China’s growth rebalancing and economic management. Reforms in financial market liberalization have not progressed and there are questions on the central government’s bone fides on the commitment to other market-oriented reforms. And as seen this week, there are serious questions on the government’s ability to manage gyrations in the market. Throwing money at the problem – which has been Chinese authorities’ strategy in the past – may not be good enough anymore. So the world is closely watching – Is China’s sneezing a symptom of an inner bacteria that’s weakening growth dynamism or just a short-lived allergy?

This is the 21st article in the ‘Smart Future’ column that advances ideas on competitiveness, innovation, and economic reforms.

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