China, once the darling of all investors, has since the collapse of 2008 thrown them one investment curve ball after another. This year is no exception. June in particular saw Chinese financial markets plunge under the weight of stark liquidity shortages, misdirected credit flows, gyrating interest rates and frightening signs of economic weakness. Many commentators in response have voiced fears of a Chinese collapse on a par with the U.S. subprime crisis and, for the second time is as many years, they have prophesied a "hard landing" for China's economy.
Although it faces many difficulties, including a tricky fundamental adjustment, China doubters surely overstate the downside. Beijing has an array of policy options at its disposal with which to mitigate strains, while China's economy and its financial markets still offer many exciting opportunities. Rather than economic and market decline, likelihoods suggest that China will avoid financial collapse as well as the dreaded hard landing, even as Beijing pursues longer-term economic and financial reform. Continued uncertainty and unavoidable missteps will create volatility going forward, but over the longer term, exposure to this economy and its financial markets should produce handsome rewards.
Rocky Road Ahead
Part of China's problem comes from its need to pursue two contrary policy objectives simultaneously. On the one side, the authorities want to tamp down excessive real estate speculation and other flows of credit for dubious projects, often promoted by provincial and local authorities and supported by what the Chinese call "shadow bankers," an uneven mix of trust companies, small lenders, leasing companies and securitizations. At the same time, the authorities want to provide sufficient credit to achieve the country's targeted overall real growth of about 7.5%. They also seek a fundamental reorientation of China's economy away from a purely export-driven growth model toward a more domestically driven one, what China's new president, Xi Jinping, refers to as the "Chinese dream."
Data confirms the existence of speculative fever. Domestic credit creation surged 52% during the first five months of this year from the comparable period in 2012. The People's Bank of China recorded that in early June alone domestic credit increased over 1 trillion yuan ($163 billion), an amount, it notes, that has never been seen in China's history.
At the same time, the all-important manufacturing and export sectors have shown signs of weakness. The HSBC Purchasing Managers' Index for China came in recently at 48.2%, well below the 50% demarcation between growth and decline. New orders for industrial equipment and supplies have declined as well, dashing hopes for any near-term pickup in buying. Exports, faced with slow growth in the United States and outright recession in Europe, have weakened, falling in the latest report 3.5% below year ago levels.
Many China watchers suggest that the real economy, which grew at a 7.6% annual rate during this year's first half, might miss the official 7.5% target for the year. Such an event, although not a hard landing, would be the first since the 1998 Asian financial crisis and would reinforce negative predictions for the future.
The PBOC's June effort to serve the dual policy objective of resisting speculation but sustaining growth was a disaster. The bank believed that a sternly worded directive indicating its lending preferences would stem speculative loans. Many lenders did not comply. When the bank provided what it believed was just enough credit to help sustain the real growth target but deny funds to speculative interests, total actual demand outstripped the PBOC's carefully calibrated supply.
Overnight lending rates soared from a relatively low 2.78% to spikes that at times approached 30%. The sudden rate climb caused Chinese stock prices to collapse, and raised questions about whether the already weakened economy could survive. The PBOC was able to ease the situation quickly and almost entirely simply by injecting more funds into the system.
June's blunder, embarrassing as it was, will not likely change China's basic policy course. The lesson may prompt the PBOC to adjust less precipitously than it had originally planned, but that is all.
Anticipating the strains in China's predicament and understanding that domestic development by its nature unfolds more gradually than export-driven growth, China's leaders have talked down economic growth prospects. By doing so now, they can avoid any appearance of failure in a later slowdown and can raise the prospect of a pleasant surprise toward the middle of their tenure. Accordingly, both President Xi Jinping and Premier Li Keqiang have shown a remarkable tolerance for slower growth and a similarly remarkable reluctance to engage in the stimulus efforts that China has resorted to in the past and that some China watchers expected.
Difficult as its chosen path is, probabilities suggest that China will manage something close to the balance its leadership seeks. To begin with, the country's real estate excesses, although dangerous, are unlikely to wreck the economy. Chinese homebuyers are not nearly as leveraged as Americans are. They must put down a minimum of 20% on their first home and 50% on their second. The financial leverage lies with local and provincial governments, which, if distressing, is at least a known quantity and much easier for Beijing to deal with than the diffused sub-prime disaster was for Washington.
What's more, China still has tremendous domestic development potential, enough to make the 7.5% growth target easily achievable for a time, even if exports remain constrained by slow global growth. There are already signs that the basic reorientation may have gained traction. Although exports and hence manufacturing have slowed and even declined by some measures, Chinese retail sales have shown strength, rising 12.9% recently from year-earlier levels.
The PBOC, despite last June's mishap, also has the power to direct credit flows, much more than the Federal Reserve does in the United States. Most of China's large lenders are government owned. It is quite plausible that policy over time can simply direct credit flows, as desired, away from speculative activities and toward longer-term developmentment. Against this array of considerations and options, China, even with slower growth and a few rough patches, looks likely to meet its growth targets and avoid a hard landing.
Although these likely events ultimately promise investors good returns, there still is no getting away from the volatility in this complex situation. Nor is there an easy way to hedge the volatility in bonds and especially in equities. Investors could, however, gain a measure of Chinese exposure and avoid much of the volatility with a portfolio of holdings from developed and emerging economies that will benefit from China's success in this effort. There are, of course, the usual mining companies that have long gained from the demands of China's still fast-growing economy. But especially as China begins to re-orient its economy toward domestic development, it will increasingly open opportunities for heavy equipment, technology and even consumer products firms.
Milton Ezrati is senior economist and market strategist for Lord, Abbett & Co. and an affiliate of
the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. He writes frequently on economics and finance. His new book, Thirty Tomorrows, linking globalization to aging demographics, is forthcoming from Thomas Dunne Books of Saint Martin's Press.
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