China Crisis Still a Possibility

This time last year, China was grabbing headlines due to a precipitous drop in its stock market and heightened volatility of its currency.

One year later, anxiety in the equity market has stabilized and volatility in the yuan has abated somewhat. But the tension between balancing dual goals of high growth and economic reform is what will define China's story this year.

China's long-term plan to prompt economic growth through consumer and service-led activity rather than industrial production expansion--all the while maintaining modest growth--requires reforms.

But high growth and economic reforms have shown to be incompatible.

The Chinese government's number-one priority is to create jobs for its 1.4 billion people and to preserve its power. To hold on to it, Beijing has been propping up the economy by stimulating and expanding credit. This, however, will only make more difficult the already challenging task of engineering a soft economic landing in the long term, experts say.

"Maintaining high growth requires the government to induce credit and increase fixed-asset investment, yet doing so exacerbates the very problems that reforms are intended to address--mainly China's swelling debt burden and widespread overcapacity throughout the economy,” said Daniel Rohr, Morningstar's director of basic materials research.

Any of the reforms that China will need to implement to put the economy in a sounder long-term growth trajectory were de-prioritized in 2016 in favor of boosting short term growth, Rohr added.

China's economy has stabilized thanks to the aggressive credit extension and infrastructure spending in the "old economy" or sectors that require relatively low skill levels, are more state-led, and more capital intensive, such as construction, Vanguard Research noted.

Chinese President Xi Jinping and the communist party's objective is to maintain stability, create jobs, and bolster growth while pushing economic reforms. But with an aging population, the prolonged industrial overcapacity, and falling productivity growth, it could take longer than expected to foster the innovation that the country needs to reach the next phase of its development.

Growing Debt The country's debt burden mounted in 2009, when the government launched a near $600 billion economic stimulus plan that triggered a wave or borrowing by state-owned enterprises.

China's political obsession with meeting official growth targets has heightened the pace of indebtedness. In 2016, the country's debt reached more than 250% of GDP, and much of it was held by state firms encouraged to borrow in order to fund infrastructure projects to incentivize growth.

China's economy grew 6.7% in 2016, and it is forecast to slow to 6.5% this year and to 6.0% in 2018, according to the International Monetary Fund. The government has said the country needs economic growth of 6.5% each year through 2020 to meet a set goal of doubling GDP and per capita income from 2010.

However, maintaining growth above 6.5% by relying on policy stimulus measures that have stoked rapid expansion of credit raises the risk of a sharper slowdown or a financial crisis, and the ongoing capital outflow pressures can exacerbate these risks.

The government has been using methods to control the pace of the yuan's depreciation such as foreign exchange intervention, interest-rate moves and capital controls.

Last year, the Chinese government introduced various restrictions to stop the currency from leaving the country. These outflows pressured the value of the yuan and by the end of the year it had shed almost 7%, to near 8 1/2 year lows.

"This is the time of year when the annual quota for sending money overseas for various Chinese entities get reset so there is an added danger of capital outflows early in the year," said David Kelly, chief global strategist at JPMorgan Asset Management.

China has also intervened by propping up the currency using foreign-exchange reserves, which fell to $3.011 trillion in December of 2016, the lowest level since early 2011.

Possibility of a Crisis In the past few months the Chinese economy seemed to have stabilized if not expanded, according to the latest manufacturing data out of China.

Yet analysts say the uptick in the Caixin PMI reading for December is a direct consequence of the government's stimulus working its way through the system into state-owned enterprises, fixed asset investment projects, and local government investments that is giving the economy a short-term burst of activity, but also more bad debt.

Still, the People's Bank of China and other arms of the government will likely directly intervene to inject liquidity into the system if Chinese banks ever face a financial crunch due to the current overextension of debt, averting any financial crisis.

"In many ways it is hard for China to have a spontaneous crisis, because unlike an open economy such as the U.S., all parts of the system are controlled by the government," said Arjun Divecha, head of emerging markets at GMO LLC.

The mortgage crisis that emanated from the U.S. reverberated into a full-blown global financial crisis in 2008-2009, but China's exponential debt growth is likely to be less infectious.

"If the global financial crisis was more akin to the flu, a China financial crisis would be more akin to Ebola," Rohr said. "The flu annually kills many more people than Ebola. That is not because it's more dangerous, it's because it's more infectious."

The global financial crisis spread through international markets because banks across the globe held U.S. mortgage debt on their balance sheets. By contrast, the global financial system has far less exposure to the Chinese banking system, and so it’s harder to catch a China crisis disease.

What is likely to come out of China is a productivity crisis, experts say, where repeated government efforts to stimulate the economy to prop up overleveraged banks and companies will exert a drag on productivity as capital and labor will persistently be misallocated.

"It could become a Japan-type scenario, muddling through for years to come," Rohr added.

Trump, Trade, and Investment The biggest external unknown for China this year is the new president of the United States. During his election campaign, President Donald Trump threatened to slap a 45% tax on Chinese imports. Now at the helm of China's biggest trading partner, he will need a procedural excuse to do so, but in the meantime his strong stance could give the U.S. a firmer footing in trade negotiations.

"What Trump is saying to the Chinese is that he is going to try to force them to choose between nationalism and mercantilism," Divecha said.

"They have had the luxury to do both. They have been able to promote their own businesses in other countries while preventing people coming into their country and making money in an open way, and that is what Trump is attacking."

The possibility of a trade war between the world's two largest economies is likely to have repercussions worldwide. But the new administration could use the threat as leverage to get concessions from its biggest trading partners, China and Mexico.

China will need to walk a policy tightrope since it would want to simultaneously try to work with the new administration, but also maintain face both domestically and around the world.

Meanwhile, less than a week in office, Trump pulled the U.S. out the Trans-Pacific Partnership trade agreement, which doesn't include China.

"The U.S. withdrawal from TPP creates an opening for China to develop its own trade infrastructure in the region and possibly strengthens China's hand in geopolitical terms as well," Rohr said.

For U.S. investors, China's internal economic policies are less relevant, said Robert Johnson, director of economic analysis at Morningstar. But as the world's largest consumer of commodities, aluminum, and copper in particular, China's appetite can hurt or benefit U.S. companies in these sectors.

For example, commodity prices plummeted in 2014, in tandem with Chinese economic deceleration, causing commodity-exporting countries to fall into recession and companies to go into bankruptcy.

But China's continued manufacturing and construction stimulus has supported growth and allowed commodities--and producers--to recover. That, however, is likely to exacerbate China's economic problems and ultimately prove unsustainable, Rohr said.

"If China has a hard landing, that destabilization could cause a surge in the value of the U.S. dollar, which could cause further problems for U.S. exports in general," Kelly added.

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.